Return on equity (ROE)

The formula

• ROE = 100 · N / E

N is the net income for the year, after interest and tax, and E the shareholders’ equity. The 100 makes it a percentage: what the owners’ capital returned over the year.

A worked example

A company earns 120,000 after tax on equity of 800,000: ROE = 100 · 120,000 / 800,000 = 15%. The same profit on equity of 1,500,000 would be 8%.

Borrowing raises it

ROE divides by the owners’ money only. A company that finances itself with loans as well as equity earns on all its assets but divides by the smaller part, so the same business with more debt shows a higher ROE, as long as the assets earn more than the loans cost. That is why ROE is read beside the equity ratio or the debt-to-equity ratio: 15% on 40% equity and 15% on 80% equity are not the same achievement.

Which equity

Equity changes during the year as profit is added and dividends paid out. The formula takes one figure; annual reports often use the average of the opening and closing balance, and a comparison between companies has to use the same convention.

Common mistakes

• Using operating profit. ROE is after interest and tax; profit before them belongs in ROA or ROIC.
• Reading a high ROE as a safe one. Thin equity makes any profit look large against it, and a loss just as large.
• Comparing a bank with a shop. Industries carry different amounts of debt as a matter of course.

Frequently asked questions