Calculating Return on Equity (ROE)

Return on equity is a measure of a corporation's rate of return on the stockholders' ownership interest. The return is based on the profit the corporation created when compared to the total amount of shareholder equity. Before you can understand how return on equity is calculated, you must first understand how to calculate a balance sheet. A balance sheet provides a measure of a company at a particular point in time. The three major areas covered in a balance sheet are assets, liabilities and shareholder equity.

Shareholders' Equity

As a company operates, it will have assets and liabilities. When assets exceed liabilities, the excess is referred to as "shareholders' equity." This equity represents the ability of management to operate the business successfully and generate surpluses that can be used for future expansion or be paid to the shareholders.

Why ROE Matters

Many investors will use the ROE calculation to determine how profitable a company is as well as its ability to sustain growth in the future. Investors prefer to invest in companies with a higher ROE value because they feel that will provide the greatest return on their investments.

Variations in the Calculation

It is not uncommon for investors to use different variations of the above formula in their calculation of return on equity. One of the variations involves subtracting preferred dividends and preferred equity from the equation. There are two classes of stock: preferred and common. Preferred stock is always paid before common. Some investors remove the preferred stock from the calculation to see the ROE using just common stock.

Another variation is to use an average of shareholders' equity. Shareholders buy and sell shares of the company during the year, so this number is volatile during the year. To negate this volatility, some investors will take the amount of shareholders' equity at the beginning of the year and add it to the amount of shareholders' equity at the end of the year and divide it by 2 to get the average.

DuPont Model

Since return on investment is a calculation based on three inputs, two companies can have the exact same ROE calculation but be vastly different in their market stability. For this reason, a modification was made to the original formula that would allow investors to compare companies in the same market.

This modification, the DuPont model, multiplies the net profit margin, asset turnover and an equity multiplier to calculate ROE. The equation is:

ROE = (Net Profit Margin) x (Asset Turnover) x (Equity Multiplier)

The DuPont Model was derived to compare a company’s performance more closely with that of others in the same market industry. This shows how well a company performs compared to its peers.

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