Return On Equity

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What is Return On Equity? Description

ROE is an accounting valuation method similar to Return on Investment (ROI). Return on Equity (ROE) is one measure of how efficiently a company uses its assets to produce earnings.

Return on EquityBecause the numerator (Net Income) is an unreliable corporate performance measurement, the outcome of the formula for ROE must also be unreliable to determine success or corporate value.

However the formula still shows up in many annual reports.

Return on Equity overstates economic value

The degree to which ROE overstates the economic value depends on at least 5 factors.

  1. Length of project life. If this is longer, the overstatement will be bigger.
  2. Capitalization policy. If the fraction of total investment capitalized in the books is smaller, the overstatement will be bigger.
  3. Rate at which depreciation is taken in the books. Depreciation rates that are faster than straight-line basis will result in a higher ROE.
  4. Lag between investment outlays and earning back these outlays from cash inflows. If the time lag is greater, the degree of overstatement will also be greater.
  5. Growth rate of new investment. Fast growing companies will have lower Return On Equity.

On top of this, ROE is sensitive to leverage: because it assumes that proceeds from debt financing can be invested at a return greater than the borrowing rate, the ROE will increase with greater amounts of leverage.

Calculation of Return on Equity. Formula

Net Income / Book Value of Shareholders' Equity = ROE

Book: Steven M. Bragg - Business Ratios and Formulas : A Comprehensive Guide

Book: Ciaran Walsh - Key Management Ratios

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Return On Equity Special Interest Group.

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The Relationship between Return on Assets ROA and ROE

Equity Multiplier
There is a direct relationship between the Return on Assets ROA (ROA = net profit after tax / assets) and the ROE. This ...
Information Sources

Various sources of information regarding Return On Equity. Here you will find powerpoints, videos, news, etc. to use in your own lectures and workshops.

ROE Models

Comparing ROE / CAPM models
Paper by Don (Tissu) U.A. Galagedera provides a review of the main features of asset pricing models. The review includes...

Return on (Common) Equity

Market Reaction to ROCE
This study by Eli Amir and Itay Kama examines investor reaction to return on common equity (ROCE) and its components aro...

Return On Equity Diagram

Accounting Valuation
Download and edit this 12manage PowerPoint graphic for limited personal, educational and business use. Republishing in ...

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Compare with Return on Equity:  EBIT  |  EBITDA  |  Economic Value Added  |  Cash Ratio  |  Current Ratio  |  Earnings Per Share  |  Return on Invested Capital  |  Return on Invested Capital  |  P/E Ratio  |  PEG Ratio  |  Economic Margin  |  DuPont Model

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