Thus, ROE is equal to a
fiscal year's
net income (after
preferred stock dividends, before
common stock dividends), divided by total equity (excluding preferred shares), expressed as a percentage.
Because shareholder's equity can be calculated by taking all assets and subtracting all liabilities, ROE can also be thought of as a return on
NAV, or assets less liabilities.
ROE is especially used for comparing the performance of companies in the same industry. As with
return on capital, a ROE is a measure of management's ability to generate income from the equity available to it. ROEs of 15–20% are generally considered good.[2]
ROE is also a factor in
stock valuation, in association with other
financial ratios. Note though that, while higher ROE ought intuitively to imply higher stock prices, in reality, predicting the stock value of a company based on its ROE is dependent on too many other factors to be of use by itself.[3]
The
DuPont formula,
[4]
also known as the strategic profit model,
is a framework allowing management to decompose ROE into three actionable components;
these "drivers of value" being the
efficiency of operations, asset usage, and finance.
ROE is then
the
net profit margin multiplied by
asset turnover multiplied by
accounting leverage:
Splitting return on equity into the three components, makes it easier for
financial managers to understand changes in ROE over time. For example, if the net margin increases, every sale brings in more money, resulting in a higher overall ROE. Similarly, if the asset turnover increases, the firm generates more sales for every unit of assets owned, again resulting in a higher overall ROE. Finally, increasing accounting leverage means that the firm uses more
debt financing relative to
equity financing. Interest payments to
creditors are
tax-deductible, but dividend payments to shareholders are not. Thus, a higher proportion of debt in the firm's capital structure leads to higher ROE.[2] Financial leverage benefits diminish as the risk of defaulting on interest payments increases. If the firm takes on too much debt, the
cost of debt rises as creditors demand a higher risk premium, and ROE decreases.[5] Increased debt will make a positive contribution to a firm's ROE only if the matching
return on assets (ROA) of that debt exceeds the interest rate on the debt.[6]
Identifying the sources of ROE in this fashion similarly allows
investment analysts a better knowledge of the company and how it should be
valued.[1] Here, analysts will compare the current sources of ROE against the company's history and its competitors, and thereby better
understand the drivers of value. In particular, as mentioned, ROE is used developing
estimates of a stock’s growth rate, and hence the growth rate of its
dividends. These then feed, respectively, into the
terminal value calculation, and / or the
dividend discount model valuation result. Relatedly, this analysis allows management to preempt any underperformance vs
shareholders' required return,[7] which could then lead to a decline in
share price, as, "in order to satisfy investors, a company should be able to generate a higher ROE than the return available from a lower risk investment".[8]