Return on Equity
Return on Investment Formula: Return on Equity
| Return on equity is one of the most important financial ratios in business. It measures how well a company used business equity to generate profits. |
Many analysts believe that the return on equity ratio measures the bottom line performance of business more than any other financial 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).
Return on Investment Formula:
How to Calculate Return on Equity
| ROE = Net Income/Average Business Equity or Owners Equity |
| Average Business Equity = (Beginning Business Equity + Ending Business Equity)/2 |
Business Equity: Stockholders Equity vs. Owners Equity
| Owners Equity refers to equity invested in the company by a sole proprietor or partnership. Shareholders Equity represents equity invested in a public corporation from stock purchases.
Both Owners Equity and Shareholders Equity represent the amount invested in the business, plus profits from the business. Net earnings increase the owners equity account for a proprietorship or partnership, and the retained earnings and stockholders equity account for corporations. |
When a company has a high return on equity, it is efficiently using the assets that investors have provided to it by increasing the business equity, or value of the company.
The importance of return on equity (ROE)
| A high ROE number directly translates into strong earnings growth, an increase in business equity, an increase in the intrinsic value of the company, and, if publicly traded, an increase in the stock price. |
See how net income increases business equity here.
Financial Leverage and Return on Equity
Recall from the accounting equation that debt, or financial leverage, reduces owners equity:
| Assets – Liabilities = Owners Equity |
Therefore, the more financial leverage that a company carries, the lower the owners equity balance, and the higher the return on equity. For this reason it is important to compare the return on equity financial ratio with industry standards. Some industries, such as the construction industry, require more debt than the software industry, which tends to have less capital-intensive assets and liabilities.
Companies use financial leverage to increase the return on equity by borrowing at a cost that is less than the investment returns received from the financial leverage. Problems arise when the company risks taking on too much debt and the industry or the overall economy changes, interest rates rise, and return on equity is eventually reduced. Companies with too much financial leverage risk higher interest payments, loan defaults, or even bankruptcy.
Companies with low debt levels and high return on equity numbers are even more efficient at utilizing business capital to increase equity. Technology companies, for example, with clean balance sheets (low debt levels) often post high return on equity numbers due to high profit margins, not from high debt levels that reduce the equity base.
The average equity is computed by taking the ending owners equity balance of $65,283 as of December 31, 2010 on the accounting balance sheet plus the beginning balance of zero (Beginning Balance = Prior Period December 31, 2009 ending balance which was zero since Sunny started the business in 2010) and computing return on equity as follows:
Return on Equity Formula Example
| Average Business Equity = (0 + 65,283)/2 = 32,642 |
| ROE = 15,283/32,642 = 46.8% |
Now let’s compare the industry averages for ROE:
Industry Ratios: Return on Equity
| Company | Return on Equity |
| Microsoft | 44.2% |
| Software Industry | 29.1% |
| Sunny Sunglasses Shop | 46.8% |
| Specialty Retail, Other | 14.7% |
| Sunglasses Hut Int. (Luxottica Group) | 13.0% |
| S&P 500 | 26.2% |
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:
Industry Ratios: Return on Equity 5 Year Averages
| Company | Return on Equity 5 Year Averages |
| Microsoft | 43.7% |
| Software Industry | 28.2% |
| Sunglasses Hut Int. (Luxottica Group) | 15.9% |
| Specialty Retail, Other | 12.6% |
| S&P 500 | 23.5% |
Microsoft and the Software Industry maintained strong return on equity averages over five years, as did Sunglasses Hut Int. (Luxottica Group) and even the S&P 500, while Specialty Retail dropped slightly. Strong short-term earnings performance boosts ROE, but is more difficult to maintain in the long-term.
Overall, the five-year averages indicate 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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