What to Do
ROE is simply net income divided by stockholder equity, expressed as a percentage:
The figure for net income should appear on the company tax return, while stockholder equity can be taken from the balance sheet.
Example:
Suppose a company’s net income is $500,000, and stockholder equity is $2.25 million.
What You Need to Know
- Although the basic formula for ROE is very simple, there are occasional variations—so investors should check carefully.
- Ideally, ROE should be in double figures. Typically, a return of more than 20% is good; investors may be satisfied with 15%. To check that a company is capable of sustaining a certain level of ROE, it’s a good idea to look at average figures over a longer period.
- Bear in mind that financial statements use "book value" (purchase price minus depreciation) to determine the value of assets—not their replacement value. If a company has new assets, ROE is likely to be lower than a company whose assets have depreciated significantly.
- It’s worth looking at ROE alongside return on assets (ROA), because the latter helps determine whether a company is balancing its debt successfully. A business that owes very little is probably making effective use of its assets, and generating good profits as a result.
- Another explanation for high ROE could be leverage (how much debt is used to finance a company’s assets). A high level of debt will show up on the balance sheet, and should be carefully examined.
