Return on Equity Calculator
Calculate the return on equity using our ROE calculator below. Keep reading to see the return on equity formula and learn more about how to find it.
Return on Equity:
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How to Calculate Return on Equity
Return on equity (ROE) is a ratio that corporations use to measure how much profit they earned as a percentage of their shareholders’ equity. ROE uses variables from multiple financial statements: net income (profit) is found on the income statement, and shareholders’ equity is found on the balance sheet.
ROE is a measure of efficiency. The higher a company’s ROE relative to other companies in its industry, the more efficient the business owners are at generating profits.
It is important to compare ROEs between companies in the same industry because companies in different industries can have very different ROEs. For example, grocery stores will typically have an ROE close to 10%, whereas technology companies can have a return on equity above 30%.
Return on Equity Formula
ROE can be easily calculated using this return on equity calculator or the following formula:
ROE = net income / shareholders’ equity
Let’s compare two companies within the same industry. Company A has shareholders’ equity of $100 million and net income of $15 million. Company B has shareholders’ equity of $40 million and net income of $8 million.
Company A ROE
ROE = $15 million / $100 million
ROE = 0.15 = 15%
Company B ROE
ROE = $8 million / $40 million
ROE = 0.2 = 20%
Company B, although smaller in size, has a return on equity slightly higher than Company A.
ROE is really just a ratio, and the calculator above calculates the same value as our ratio calculator.
Why is Return on Equity Important?
Return on equity is important because it provides a way to measure the performance of the managers of a particular company. The primary goal of a profit-seeking company is to generate income for the business owners, and the business owners will want the company to make as much income as possible.
One of the easiest ways to calculate ROE is with the calculator above.
The net income is the amount that could be distributed to the owners in the form of a dividend. Shareholders’ equity is the value of the business that the business owners own.
Return on equity is basically just another name for the return on investment for business owners in a particular year.
If the owners of the business are not directly running the business (as in the case with many publicly traded companies), they can decide to remove the managers who are not running the business well.
Let’s return to the example of Company A and Company B to see how this works.
While Company A appears to be over twice as large as Company B, it is not as efficient at generating net income as Company B. But if Company B were able to double in size and keep its same return on equity, it would begin to make more profits than Company A.
If Company B doubles to $80 million in shareholders’ equity and retains its 20% ROE, it will make $16 million in net profit. If it increases further to $100 million in shareholders’ equity (the same as Company A), it would hypothetically earn $20 million in profits. This shows that it is more efficient than Company A.
While they may not necessarily make a decision right away, the owners of Company A will see this and may start to lose faith in the managers. If this continues year after year and Company B eventually reaches the same size as Company A, then Company A’s owners may be more inclined to vote out the current managers.
The ROE also gives a company a chance to compare its current performance to its past performance. If its ROE is increasing at a healthy rate, the business is growing and becoming more efficient.
So if in one year, Company B increases its shareholder’s equity from $40 to $45 million and net income from $8 to $10 million, its ROE will increase from 20% to 22%. This would be an encouraging sign to the business owners that the company is being run well.
What is a Good Return on Equity?
While there is no single standard for a good ROE, there are a few things that a business will want to achieve.
First, it will want the ROE to be a positive percentage. This means that the company is making a profit instead of losing money.
Also, the company will want to compare its ROE to itself. If the ROE improves over time, the company is becoming more efficient. If the ROE is not increasing, the business owners will want to make sure that at least the net income is growing each year.
If neither is growing, this will usually be a cause for concern.
Finally, as already discussed, a good ROE is one that outperforms its peers.
A company has a good ROE if it is able to make positive profits each year, increase its ROE over time, and have an ROE that is above its peers.
ROE vs. ROI
The return on investment (ROI) is another measure of profitability. ROI calculates the amount of profit earned on an investment over a period of potentially many years, whereas the ROE measures the amount of profit earned in a year as a percentage of the value of a company.
The ROI provides an annualized compounded growth rate. Similar to the ROE, the ROI is best used when it can be compared to something else. Since this is an investment, it can be compared to a particular benchmark.
For example, let’s say someone invested in a particular company in the S&P 500 (let’s call it Company C) at $100 per share, and it increased to $250 per share after ten years. If we plug these amounts into our ROI calculator, we would get an ROI of 150% and annualized ROI of 9.6%.
The annualized rate of return can also be found using a rate of return calculator. This is more important than the total return on investment because it allows us to more easily compare two investments.
If over the same time period, the S&P increased by 120%, it would have an annualized ROI of 8.2%. Since Company C is in the S&P 500, we know the S&P 500 is a comparable benchmark, and therefore, Company C outperformed it.
A 1.4% difference in annualized ROI between Company C and the S&P 500 may not seem like a large amount. But due to the impact of compound growth, this will turn out to be a substantial difference over time.