Return on equity (ROE)

Return on equity (ROE) measures net profit relative to the shareholders’ equity supporting a business. It shows the accounting return generated on owners’ recorded capital, but its interpretation depends on leverage, asset values, buybacks and the sustainability of earnings.

When to use it

• Answer the key performance question: “How efficiently are we using the investments that shareholders have made to generate profits?”
• Include the KPI in the financial perspective.
• Compare profitability over time and among businesses with comparable economics and accounting.
• Decompose the result to understand the effects of margin, asset use and financial leverage.

Origins

ROE emerged from financial-statement ratio analysis and the early return-on-investment systems used by industrial firms. The DuPont framework made the measure especially useful by decomposing it into profit margin, asset turnover and an equity multiplier. That decomposition remains essential because the same headline ROE can arise from very different operating and financing choices.

What it is

Perspective: Financial perspective.

Key performance question: How efficiently are we using the investments that shareholders have made to generate profits?

ROE is net income available to common shareholders divided by common shareholders’ equity, usually averaged over the period. It is an important investor measure, but it is not a complete score of management. A high result may reflect strong economics, high debt, a very small or negative equity base, share repurchases, accumulated impairments or cyclical peak profit.

Businesses that earn attractive ROE without excessive leverage may be able to fund growth from retained earnings. Whether they can do so depends on reinvestment opportunities, payout policy and the capital required for expansion—not on ROE alone.

Compare companies within a relevant sector and examine the denominator. Banks, insurers, industrial companies and asset-light software businesses have fundamentally different capital structures and constraints.

How to use it

Measurement

Use net income attributable to the equity class in the denominator. Average opening and closing equity when profit is earned across the period, and adjust interpretation for major issuance, buybacks, dividends, acquisitions or impairments.