Return on Equity

Quick Summary
1. Calculate historical ROE by dividing net income from the current period by the average book value of equity.
2. Estimate future ROE by reviewing a firm’s marginal returns and the industry average.
3. Conduct a DuPont analysis of ROE.

1. Calculate Historical ROE
Return on equity (ROE) measures the profitability of a firm from the perspective of an equity investor. It has the added computational simplicity over return on capital (ROC) in that no adjustments are required to remove non-operating items. Note that ROE is more volatile than ROC, largely as a consequence of leverage.

ROE formula

ROE should be calculated using net income from the current period and estimated after preferred dividends. Book value of equity can be estimated from the end of the previous period or the average of the current and previous periods. It is defined as the difference between total assets and total liabilities. It should not include the book value of any preferred stock. No adjustments are required for operating leases since both the book value of equity and net income are unaffected by the conversion to debt.

If cash balances are significant, after-tax interest income can be subtracted from the numerator and cash and marketable securities netted out of the denominator. Analysts will also restate financial statements for any prior adjustments, such as changes in accounting methods, to keep reported years logically consistent.

ROE calculations should distinguish between the results of the parent and any affiliates if income from associates represents a significant percentage of net income . This involves subtracting the share of results from associates out of net income and excluding the investment in associates from total assets. It is worth looking more closely at investment holdings if associates’ contribution to ROE is high.

2. Estimate Future ROE
While historical trends in ROE may provide some indication of future returns, other considerations are worth keeping in mind. ROE, for example, exhibits strong mean reversion. In the long run ROE should eventually converge with the industry average or the cost of equity. How quickly a firm’s ROE fades toward the stable rate is dependent on the current causes of the excess returns (e.g. high barriers to entry or accounting anomalies) and whether they can be sustained into the future.

Another leading indicator of future returns is the marginal return on equity. While the conventional calculation of ROE measures the return on both older and newer investments, the marginal return on equity conveys the return only on recent projects. It is calculated as the change in net income divided by the change in the book value of equity.

3. DuPont Analysis
DuPont analysis involves decomposing ROE by a firm’s net profit margin (=net income / sales), total asset turnover (=sales / total assets), and financial leverage (=total assets / shareholders’ equity). Disaggregating and isolating the components of ROE in this manner provides analysts a window into the trends underlying ROE. Such granularity can also reveal more threads to follow in assessing the drivers of earnings.

DuPont Analysis

Net profit margin can be decomposed further into a firm’s tax burden (=net income / EBT), interest burden (=EBT / EBIT), and EBIT margin (=EBIT / revenue). Note that an increase in the tax burden signals a decrease in the effective tax rate.

Concluding Thoughts
Stock buybacks have the effect of reducing a firm’s book value of equity and therefore increasing ROE dramatically. A possible adjustment to account for this occurrence is to add back share repurchases from recent years to shareholders’ equity. Re-calculating ROE in this manner can sometimes yield a better estimate of ROE.

Suggested Reading
The Motley Fool. Return on Equity: An Introduction.

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