What return on equity tells you
Return on equity compares the profit for a period with the shareholders’ stake in the business. Net income is the profit left after all expenses, interest and taxes. Shareholders’ equity is total assets minus total liabilities: mainly the capital owners have put in plus the profits the business has kept over the years.
If the company has preferred shares, use net income available to common shareholders, which is net income minus preferred dividends. Preferred shareholders have a prior claim on dividends, so that part of the profit is not available to common shareholders.
A result of 15.0% means the business earned 15 of net income for every 100 of shareholders’ equity it had, on average, during the period. A negative result means the business made a loss.
Reading a high or low result
- A higher ROE can come from wider margins or from getting more revenue out of the same assets. It can also come from more debt and less equity, which adds financial risk rather than reflecting better operations.
- A lower ROE can point to thin margins or underused assets. It can also reflect a business funded mostly by its owners, which carries fewer fixed interest and repayment obligations.
What is normal varies by industry and by how businesses are financed. Compare ROE with the same business in earlier periods, or with similar businesses that report on the same basis.
How leverage raises ROE
Borrowing lets a business hold more assets than its shareholders’ equity alone would pay for. If those extra assets earn more than the interest on the debt, the surplus goes to shareholders, and ROE rises even though their investment has not grown. The effect also works in reverse: when returns fall below the cost of borrowing, the interest still has to be paid, and ROE falls further than it would without debt.
For this reason, read ROE alongside leverage measures such as the debt-to-equity ratio. A DuPont analysis splits ROE into margin, asset turnover and leverage, so you can see how much of the result comes from borrowing.
What ROE does not show
- It does not show risk. Two businesses with the same ROE can carry very different amounts of debt.
- It becomes misleading when equity is small. Years of losses or large payouts to shareholders can shrink equity until a modest profit produces a very large ROE. When equity is negative, the calculator does not give a result.
- Equity is a book value. It reflects what was invested and kept in the business, not what the shares are worth on the market.
Average vs ending balances
Net income is earned across the whole period, but equity is measured on one date, and it changes during the year as profits are kept, dividends are paid or new shares are issued. Averaging the opening and closing balances matches the period’s profit with the equity that was in the business across that period. If you enter only the closing balance, the calculator uses ending equity and says so in the result.
Common mistakes
- Leaving preferred dividends in the numerator for a company with preferred shares, which overstates the return to common shareholders.
- Reading a rising ROE as better performance without checking whether it came from more debt or a shrinking equity base rather than from higher profit.
- Comparing an ROE based on average equity with one based on ending equity.
- Working out ROE by hand when equity is negative. A loss divided by negative equity gives a positive figure that means nothing.
Related measures
Return on assets divides the same net income by total assets, so it measures the return on everything the business holds, however it is financed. ROE vs ROA explains when each is more useful. Return on invested capital looks at the after-tax operating return on the capital provided by lenders and shareholders together.