Return on Equity ( ROE )

Investment Formula Description

Return on Equity ( ROE ) is the investment formula to measure the rate of return on the ownership interest of  common stock owners, which is usually referred as shareholders' equity.

 On other words, return on equity ( ROE ) measures a company's efficiency at generating profits from every dollar of shareholders' equity. Return on equity ( ROE ) is useful to compare with companies in the same industry because different industries will have different business nature. For instance, IT companies with no assets and no inventories will have higher return on equity ( ROE ) than manufacturing companies with large infrastructure and high inventories. However, not all high return on equity ( ROE ) companies are good investment. As per previous examples, we cannot conclude that  IT companies with high return on equity ( ROE ) is better investment than manufacturing companies which generally will have lower return on equity ( ROE ). In business environment , high capital industries like manufacturing companies will have higher barrier to entry and thus lesser competitors and lesser risk. On the other hands, low capital industries like IT companies will have lower barrier to entry as it does not need much funding. Hence, low capital industries will have more competitors and higher business risk. As with other investment formula, return on equity ( ROE ) is best use to compare with companies in the same industry.

Unlike Earning Per Share ( EPS ), high return on equity ( ROE ) does not have immediate benefit to stock price since high return on equity ( ROE ) just proves that the companies can earn more money for every dollar invested by the shareholders. However, when the earnings are reinvested, it generally in turn gives companies a high growth rate, and eventually high compound annual growth rate ( CAGR ) . This is one of the myth of dividend payout- Distributing dividends only have positive impact on companies, which is incorrect view on dividend distributions. Distributing dividends will reduce return on equity ( ROE ) for that company since the earnings were distributed as dividend and it is not reinvested. Sometimes, return on equity ( ROE ) is also known as return on net worth ( RONW ) or return on average common equity.

Investment Formula

Return on Equity ( ROE ) = Net income ( NI ) or net profit / Shareholders' Equity

Investment Formula Examples

Corporation A with $250,000 shareholders' equity has $ 100,000 net income on this financial period. The return on equity ( ROE ) calculation as following.

Return on Equity ( ROE ) = Net income / Shareholders' Equity = 100,000 / 250,000 =  $ 0.40

Return on Equity ( ROE ) for corporation A is $0.40, which means that Corporation A is able to earn $ 0.40 for every dollar invested by the shareholder.

If Corporation A declared to distribute $20,000 of its net income as dividend to shareholders, the return on equity will be reduced as following.

Remaining Net Income = Original Net Income - Total Dividend Distribution = 100,000 - 20,000 = $80,000

Return on Equity ( ROE ) = Remaining Net income / Shareholders' Equity = 80,000 / 250,000 =  $ 0.32

In this case, the return on equity ( ROE ) for corporation A drops from $0.40 to $0.32 after distributing its net income for dividend. Hence, if a dividend payout is 20% for a company, the growth expected will be only 80% of the return on equity ( ROE ).