Return on equity

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Return on Equity (ROE, Return on average common equity) measures the rate of return on the ownership interest (shareholders' equity) of the common stock owners. ROE is viewed as one of the most important financial ratios. It measures a firm's efficiency at generating profits from every dollar of net assets, and shows how well a company uses investment dollars to generate earnings growth. ROE is equal to a fiscal year's net income (after preferred stock dividends but before common stock dividends) divided by total equity (excluding preferred shares), expressed as a percentage.

$ROE = \frac{Net\ income}{Average\ stockholders\ equity}$ ^[1]

But not all high-ROE companies make good investments. Some industries have high ROE because they require no assets, such as consulting firms. Other industries require large infrastructure builds before they generate a penny of profit, such as oil refiners. You cannot conclude that consulting firms are better investments than refiners just because of their ROE. Generally, capital-intensive businesses have high barriers to entry, which limit competition. But high-ROE firms with small asset bases have lower barriers to entry. Thus, such firms face more business risk because competitors can replicate their success without having to obtain much outside funding. As with many financial ratios, ROE is best used to compare companies in the same industry.

High ROE yields no immediate benefit. Since stock prices are most strongly determined by earnings per share (EPS), you will be paying twice as much (in Price/Book terms) for a 20% ROE company as for a 10% ROE company. The benefit comes from the earnings reinvested in the company at a high ROE rate, which in turn gives the company a high growth rate.

ROE is irrelevant if the earnings are not reinvested.

The sustainable growth model shows us that when firms pay dividends, earnings growth lowers. If the dividend payout is 20%, the growth expected will be only 80% of the ROE rate.
The growth rate will be lower if the earnings are used to buy back shares. If the shares are bought at a multiple of book value (say 3 times book), the incremental earnings returns will be only 'that fraction' of ROE (ROE/3).
New investments may not be as profitable as the existing business. Ask "what is the company doing with its earnings?"
Remember that ROE is calculated from the company's perspective, on the company as a whole. Since much financial manipulation is accomplished with new share issues and buyback, always redo the calculation on a 'per share' basis. EPS/book.

[edit] The DuPont Formula

The DuPont formula, also known as the strategic profit model, is a common way to break down ROE into three important components. Essentially, ROE will equal net margin multiplied by asset turnover multiplied by financial leverage. Splitting return on equity into three parts makes it easier 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 dollar of assets owned, again resulting in a higher overall ROE. Finally, increasing financial 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. Financial leverage benefits diminish as the risk of defaulting on interest payments increases. So if the firm takes on too much debt, the cost of debt rises as creditors demand a higher risk premium, and ROE decreases. ^[2]

$ROE = \frac{Net\ income}{Sales}\times\frac{Sales}{Total\ Assets}\times\frac{Total\ Assets}{Average\ stockholders\ equity}$