Return on Equity (ROE)

In one sentence: Return on equity tells you how many cents of yearly profit a business earns for each dollar its owners have in it.

$\text{ROE} = \frac{\text{Net income}}{\text{Shareholders' equity}}$

Read it out loud: “ROE equals net income divided by shareholders' equity. ROE stands for return on equity. Net income is the profit left after all costs, interest and taxes are paid, over one year. Shareholders' equity is the owners' share of the business. The result is a rate that you can write as a percentage.”

Before you start

The ideas and signs this page uses, explained from zero. For powers of ten, Greek letters and other notation in general, see Math basics.

Percent means per hundred: Percent means per hundred, and the symbol % stands for divided by 100. So 20% is 20 out of every 100, which is 0.2 written as a decimal. To turn a decimal into a percent, multiply by 100.
Revenue and net income: Revenue is the total money a business brings in from sales. Net income is what is left after every cost is paid, including wages, rent, interest and taxes. It is the bottom line, the profit that belongs to the owners.
Shareholders’ equity: Equity is the owners’ share of a business: its assets minus its liabilities. Shareholders are the owners, and their combined share is called shareholders’ equity. It is the owners’ money tied up in the company.
Yearly rates: A rate compares a result with a base amount over a time period. Here the profit covers one year and the equity is the base, so the answer is a return per year. A return of 20% for the year means 20 cents of profit for each dollar of equity.
Assets and asset turnover: An asset is something owned that has value, such as machines or cash. Asset turnover is revenue divided by total assets, the number of dollars of sales produced by each dollar of assets in a year.

What each symbol means

Symbol	Meaning
$\text{ROE}$	Return on equity, the result. It is a yearly rate, usually written as a percentage. An ROE of 0.20 is the same as 20%, which means 20 cents of profit for each dollar of owners’ money in one year.
$\text{Net income}$	The company’s profit for the year after every cost is paid, including wages, rent, interest and taxes. Measured in dollars per year.
$\text{Shareholders' equity}$	The owners’ share of the business: everything it owns minus everything it owes, measured at one date. Measured in dollars.

The formula piece by piece

$\text{Net income}$: Start with the top of the fraction. It is the profit the business kept for the year after all its costs, which is the reward to its owners.
$\text{Shareholders' equity}$: This is the bottom of the fraction. It is the owners’ investment in the company, the base against which the profit is measured.
$\frac{\text{Net income}}{\text{Shareholders' equity}}$: Divide the profit by the investment. The result says how much profit each dollar of owners’ money produced in the year.
$\text{ROE} = \frac{\text{Net income}}{\text{Shareholders' equity}}$: The whole formula in one sentence: return on equity equals net income divided by shareholders’ equity.
$\text{ROE} = \frac{\text{Net income}}{\text{Revenue}} \times \frac{\text{Revenue}}{\text{Total assets}} \times \frac{\text{Total assets}}{\text{Shareholders' equity}}$: The DuPont form, another standard way to write the same number. It multiplies profit margin, asset turnover and equity multiplier. Revenue and total assets cancel in the product, which leaves the simple form again.

What the formula is doing, and why

Owners put money into a business and hope to earn a good return on it. Return on equity measures that return. It asks: in one year, how much profit did the business earn for every dollar of the owners’ money it held? The answer is a rate, so it can be compared across companies of very different sizes.

Why divide net income by equity? Net income is the reward and equity is the amount the owners risked. Dividing one by the other turns a total profit into a share of the investment. Twice the profit on the same equity doubles the ROE, while twice the equity on the same profit halves it. That is why the ratio is a rate and not a size.

Why net income and not revenue? Revenue is the money coming in from sales. Net income is what remains after every cost is paid, so it is the amount truly left for the owners. A company can have large sales and still earn little for its owners if its costs take most of the money.

Where DuPont fits. The DuPont breakdown splits ROE into three parts: how much profit each dollar of sales keeps, how many dollars of sales each dollar of assets produces, and how many dollars of assets sit behind each dollar of owners’ money. Multiplying the three gives back the same ROE. Each part shows a different way a company could raise its return.

Why a high ROE is not always good. Borrowing raises the equity multiplier, so a company can lift its ROE by taking on more debt alone. That makes the business riskier. A high ROE built on heavy debt can be weaker than a modest ROE earned without it.

An everyday picture

Think of lending a friend 100 dollars to start a lemonade stand. If the stand earns 20 dollars of profit by the end of the year, your return is 20 out of 100, or 20%. The 100 dollars you put in is like shareholders’ equity, and the 20 dollars of profit is like net income. Return on equity asks the same question about a company: how much did each dollar of the owners’ money earn?

Worked example: What return did the owners of Lark Software Inc earn?

Lark Software Inc is a made-up company that makes scheduling apps. In one year it earns net income of 80000 dollars after all costs and taxes. At the end of the year its shareholders’ equity is 400000 dollars. We want the return on equity for that year. Then we will check it with the DuPont breakdown, using made-up figures of 1000000 dollars of revenue and 800000 dollars of total assets.

Write the formula and put in the numbers. We want net income divided by shareholders’ equity, so $\text{ROE} = \frac{80000\ \text{dollars per year}}{400000\ \text{dollars}}$ . Net income covers one full year, so the answer is a return for that year.
Divide the profit by the owners’ money. Dividing 80000 by 400000 gives 0.2. This means the profit is one fifth of the owners’ equity, so the owners earned one fifth of their money back as profit that year.
Turn the decimal into a percentage. Percent means per hundred, so we multiply by 100: $0.2 \times 100 = 20\%$ . Lark earned 20 cents of profit for each dollar of owners’ equity during the year.
Start the DuPont breakdown with the profit margin. Profit margin is net income divided by revenue, the share of each sales dollar kept as profit: $\frac{80000}{1000000} = 0.08$ . Lark keeps 8 cents from every dollar of sales, after all of its costs.
Find the asset turnover. Asset turnover is revenue divided by total assets, which shows how many dollars of sales come from each dollar of assets: $\frac{1000000}{800000} = 1.25$ . Each dollar of assets produced 1.25 dollars of sales during the year.
Find the equity multiplier. This is total assets divided by shareholders’ equity, showing how many dollars of assets sit behind each dollar of owners’ money: $\frac{800000}{400000} = 2$ . The owners supply half of the assets, and the other 400000 dollars is owed to others.
Multiply the three parts. Multiplying the margin, the turnover and the multiplier gives $0.08 \times 1.25 \times 2 = 0.2$ , which is the same 20% as the direct calculation. The two methods agree, so the answer is consistent.

Answer: Lark Software Inc had a return on equity of 20% for the year, which means 20 cents of profit for each dollar the owners had in the business. The DuPont breakdown shows that this came from an 8% profit margin, asset turnover of 1.25 and an equity multiplier of 2, so borrowed money helped lift the result.

The numbers in this example are recomputed by script every time the site is built.

Common mistakes

Dividing revenue by equity instead of net income. Revenue is sales before costs are taken out, so that number is far larger and gives a misleading return.
Mixing periods, such as dividing one year’s profit by equity from a different date. The profit and the equity should describe the same period.
Forgetting that many analysts use average equity. Some divide by the average of the opening and closing equity for the year, which gives a slightly different answer.
Reading a high ROE as always good. Heavy borrowing can lift ROE while making the company riskier, so check the debt level next to it.
Trusting ROE when equity is near zero or negative. Then the ratio becomes very large or meaningless, so it should not be compared directly with other companies.

Where you will meet it

Comparing companies in the same industry, to see which one turns owners’ money into profit most effectively.
Checking how management uses owners’ capital over several years, by watching whether the ratio rises or falls.
Measuring the profitability of a bank, where ROE is a standard measure of how well it earns from its capital.
Judging the quality of a business with the DuPont breakdown, which shows whether profit comes from margins, sales volume or borrowing.

Questions people ask

Why do some sources use average equity?

Equity changes during the year as the company earns profit, pays dividends or issues shares. Dividing by the average of opening and closing equity matches the profit to the capital that was in use across the whole year. Both versions are used, so say which one you are reading.

What is a good ROE?

It depends on the industry and on how much debt the company uses. Compare the figure with close competitors and with the company’s own history, rather than with one fixed target.

Is ROE the same as the return an investor earns from a share?

No. ROE measures the company’s profit on the owners’ book equity, which is an accounting figure. An investor’s return depends on the price paid for the shares and on any dividends received, so the two can differ a lot.

Net Profit Margin: Net profit margin says how many cents of profit a business keeps from each dollar of sales, after every cost has been paid.
Debt-to-Equity Ratio: The debt-to-equity ratio shows how much a business is funded by borrowing compared with money from its owners: a higher number means more debt.
Earnings Per Share: EPS says how much profit a company earned for each share of its stock, after the preferred shareholders have been paid their dividends.