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Return on Equity

Definition

In corporate finance, the return on equity is a measure of the profitability of a business in relation to the book value of shareholder equity, also known as net assets or assets minus liabilities. ROE is a measure of how well a company uses investments to generate earnings growth.

Return on Equity

Return on Equity or ROE is one of the ratios that can be used to measure the performance of an organization in terms of generating profits. It is commonly used to find the monetary efficiency of an organization. The ratio explains the strength of an organization to be able to use the available capital in order to generate income.

The common formula used for finding the ROE is as follows:

Return on Equity=(Net Income)/(Shareholder Equity)

Net Income

Net income can be termed as the original profits of a company when all of the current expenses are subtracted from it such as taxes and salaries.

Shareholder Equity

Shareholder equity is termed as the amount of net assets that are available for use to a company. This simply means that equity is the amount of assets minus the current liabilities of the organization.

What is a Good ROE?

Generally, an ROE of 15-20% is considered as excellent for a company. ROE however, is an industry specific ratio and it will not be wise to use company ROEs to compare companies present in different working industries.

There are few benefits of a high ROE if the net income is not reinvested in the business because the shares of a company with high ROE will simply be more expensive. Reinvesting major portions of the income, returns a small ROE, but improves company growth. The ROE factor is mostly prevalent for use in companies where reinvestment is a viable option.

The DuPont Formula

The DuPont Formula is also quite useful in finding the strategic value of company profits. It breaks down ROE in terms of three different components. The first part is the net profit margin which is found by taking a ratio of net income with organizational sales. The second part is the assets turnover ratio. It is found by dividing sales with the total assets. The last part is the financial leverage which is found by the ratio of total available assets over the shareholder equity.

This formula covers all the situations and it is able to provide the true ROE in an organization that may be in debt or have other financial liabilities which it has to carry out, regardless of the way the business is going. This formula can be presented in the following manner:

DuPont ROE=(Net Income)/Sales×Sales/(Total Assets)×(Total Assets)/(Shareholders Equity)


Further Reading

Is the abnormal return following equity issuances anomalous?Is the abnormal return following equity issuances anomalous?
www.sciencedirect.com [PDF]
We examine whether a distinct equity issuer underperformance anomaly exists. In a sample of initial public offering (IPO) and seasoned equity offering (SEO) firms from 1975 to 1992, we find that underperformance is concentrated primarily in small issuing firms with low book …

Legal determinants of the return on equityLegal determinants of the return on equity
books.google.com [PDF]
We examine whether a distinct equity issuer underperformance anomaly exists. In a sample of initial public offering (IPO) and seasoned equity offering (SEO) firms from 1975 to 1992, we find that underperformance is concentrated primarily in small issuing firms with low book …

PE ratios, PEG ratios, and estimating the implied expected rate of return on equity capitalPE ratios, PEG ratios, and estimating the implied expected rate of return on equity capital
meridian.allenpress.com [PDF]
We examine whether a distinct equity issuer underperformance anomaly exists. In a sample of initial public offering (IPO) and seasoned equity offering (SEO) firms from 1975 to 1992, we find that underperformance is concentrated primarily in small issuing firms with low book …

Impact of dividend policy, earning per share, return on equity, profit after tax on stock pricesImpact of dividend policy, earning per share, return on equity, profit after tax on stock prices
papers.ssrn.com [PDF]
We examine whether a distinct equity issuer underperformance anomaly exists. In a sample of initial public offering (IPO) and seasoned equity offering (SEO) firms from 1975 to 1992, we find that underperformance is concentrated primarily in small issuing firms with low book …

Using forecasts of earnings to simultaneously estimate growth and the rate of return on equity investmentUsing forecasts of earnings to simultaneously estimate growth and the rate of return on equity investment
onlinelibrary.wiley.com [PDF]
We examine whether a distinct equity issuer underperformance anomaly exists. In a sample of initial public offering (IPO) and seasoned equity offering (SEO) firms from 1975 to 1992, we find that underperformance is concentrated primarily in small issuing firms with low book …

Risk and return on equity: The use and misuse of historical estimatesRisk and return on equity: The use and misuse of historical estimates
www.tandfonline.com [PDF]
We examine whether a distinct equity issuer underperformance anomaly exists. In a sample of initial public offering (IPO) and seasoned equity offering (SEO) firms from 1975 to 1992, we find that underperformance is concentrated primarily in small issuing firms with low book …

Determinants of return on equity in US local farm supply and grain marketing cooperativesDeterminants of return on equity in US local farm supply and grain marketing cooperatives
www.cambridge.org [PDF]
We examine whether a distinct equity issuer underperformance anomaly exists. In a sample of initial public offering (IPO) and seasoned equity offering (SEO) firms from 1975 to 1992, we find that underperformance is concentrated primarily in small issuing firms with low book …

Risk and the required return on equityRisk and the required return on equity
www.jstor.org [PDF]
We examine whether a distinct equity issuer underperformance anomaly exists. In a sample of initial public offering (IPO) and seasoned equity offering (SEO) firms from 1975 to 1992, we find that underperformance is concentrated primarily in small issuing firms with low book …


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