Using the Return on Equity Formula
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Many analysts believe ROE measures the bottom line performance of business more than any other measure.
As Warren Buffet once said, "The primary test of managerial economic performance is the achievement of a high earnings rate on equity capital" (Annual Report of Berkshire Hathaway, 1979).
How to Calculate Return on Equity
ROE is calculated as:
Return on Equity Formula
| ROE = Net Income/Average Stockholders or Owners Equity |
| Average Equity = (Beginning Equity + Ending Equity)/2 |
Stockholders Equity vs. Owners Equity
| Stockholders Equity represents equity invested in a public corporation from stock purchases. Owners Equity refers to equity invested in the business by a sole proprietor or partnership. Both represent the total amount invested in the business, plus profits from the business that increase the owner's equity account for a proprietorship or partnership, and the retained earnings account for corporations. |
See how net income increases owners equity here
When a company has a high ROE, it is efficiently using the assets that investors have provided to it by increasing the equity, or value of the company.
The importance of return on equity (ROE)
| A high ROE number directly translates to strong earnings growth, an increase in owners equity, an increase in the intrinsic value of the company, and, if publicly traded, an increase in the stock price. |
Recall from the accounting equation that debt reduces owners equity, or net assets:
| Assets - Liabilities = Owners Equity |
Therefore, the more debt that a company carries, the lower the owners equity balance, and the higher the ROE. For this reason it is important to compare ROE with industry standards. Some industries, such as the construction industry for example, require more debt than industries like software, which tend to have less capital intensive assets and liabilities.
Companies with low debt levels and high ROE numbers are even more efficient at utilizing investors' money to increase equity. Technology companies, for example, with clean balance sheets (low debt levels) often post high ROE numbers due to high profit margins, not high debt levels.
The average equity is computed by taking the owners equity balance on the examples of balance sheets
of $65,283 plus the beginning balance of zero (Beginning Balance = Prior Period December 31, 2006 ending balance which was zero since Sunny started the business in 2007) and computing ROE as follows:
Return on Equity Formula Example
| Average Equity = (0 + 65,283)/2 = 32,642 |
| ROE = 15,283/32,642 = 46.8% |
Now let's compare the industry averages for ROE:
| Company | Return on Equity |
| Microsoft | 47.7% |
| Software Industry | 34.6% |
| Sunny Sunglasses Shop | 46.8% |
| Specialty Retail, Other | 25.3% |
| Sunglasses Hut Int. (Luxottica Group) | 21.8% |
| S&P 500 | 20.9% |
QuickBooks Solutions For Your Industry
Sunny Sunglasses Shop has posted impressive ROE of 46.8%, which is on par even with Microsoft. But Sunny Sunglasses Shop also has a smaller equity pool than these larger companies. Still, the company is off to a strong start compared with the industry averages.
High ROE levels may be due to a short - term factors such as:
- Restructuring charges and asset sales that lower equity and increase ROE.
- Stock buybacks that lower equity and increase ROE.
- One time gains that increase earnings and ROE.
- A strong economy or peak in the business cycle.
Because it is much more difficult to maintain high ROE levels for the long-term, it is also important to consider ROE over longer periods of time. Below are the five year averages for ROE:
| Company | Return on Equity 5 Year Averages |
| Microsoft | 20.3% |
| Software Industry | 20.9% |
| Sunglasses Hut Int. (Luxottica Group) | 20.9% |
| Specialty Retail, Other | 14.6% |
| S&P 500 | 14.2% |
The Specialty Retail industry average dropped substantially from 25.3% to 14.6%. Microsoft and the Software Industry also posted substantially lower ROE over the five year averages. Strong short-term earnings performance boosts ROE, but is more difficult to maintain in the long-term.
Luxottica posted impressive ROE for five years, indicating strong earnings and efficiency in utilizing stockholders investments.
Nearly all the companies for which Warren Buffet owns large stakes have average annual ROE numbers of 15% or greater.
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