Learning Outcomes
- Calculate the rate of return on shareholder’s equity
Return on equity (ROE) measures financial performance by dividing net income by shareholders’ equity. Because shareholders’ equity is equal to a company’s assets minus its debt, ROE is considered the return on net assets (as opposed to return on total assets).
The goal of investing in a corporation is for stockholders to accumulate wealth as a result of the company making a profit. The ratio looks at how well the investments of preferred and common stockholders are being used to reach that goal.
The following formula shows how to calculate ROE:
[latex]\dfrac{\text{net income}}{\text{average total stockholders' equity}}[/latex]
For example: [latex]\dfrac{248,000}{\frac{2,675,000+2,447,000}{2}}=9.7\%[/latex]
| Description | 2019 |
|---|---|
| Income before income tax | $314,000 |
| Income tax expense | 66,000 |
| Net income | Single Line$248,000 Double Line |
| 2019 | 2018 | |
|---|---|---|
| Stockholders’ Equity | ||
| Preferred $1.50 stock, $20 par | $166,000 | $166,000 |
| Common stock, $10 par | 83,000 | 83,000 |
| Retained earnings | 2,426,000 | 2,198,000 |
| Total stockholders’ equity | $2,675,000 | $2,447,000 |
| Total liabilities and stockholders’ equity | Single Line$3,950,000Double Line | Single Line$3,606,000Double Line |
In our example, Jonick Company shows a ROE of 9.7%, which means the owners, who together have invested about $2.5 million, are seeing the company achieve in 2019 a return on that invested capital of almost 10%.
ROE ratios vary significantly from one industry group or sector to another. For instance, utility companies overall may have a lower ROE but be more stable and less risky, whereas tech firms overall may have a higher expected ROE but the individual stocks may be riskier and more volatile.
Inconsistent profits (e.g. a net loss one year, high profits the next) can skew ROE on an annual basis. The extent of leverage (debt financing) can also affect ROE. As with any measure, this one has to be applied thoughtfully and in conjunction with other metrics.
Common variations of this metric include Return on Common Stockholders Equity (which would treat preferred stock more like debt) and Return on Invested Capital (ROIC). The formula for ROIC is (net income – dividends) / (debt + equity).
PRACTICE QUESTION
