How to calculate return on equity

ROE = net income ÷ shareholders’ equity. Net income comes from the income statement, usually the last 12 months; equity comes from the balance sheet. XYZ: $180 million ÷ $600 million = 30%. Because equity moves during the year, many data sites divide by average equity instead; use the same method for every company you compare.

ROE answers a shareholder’s question: for every dollar of book value, how many cents of profit did the company earn this year? Warren Buffett described a high return on equity, achieved without undue debt or accounting tricks, as a key test of management; see the Warren Buffett strategy. Some growth screens, such as CAN SLIM, also set a minimum ROE.

Return on equity (ROE)
Net income ÷ shareholders’ equity, usually shown as a percentage: profit relative to the book value of the owners’ stake.
Average equity
(Equity at the start of the year + equity at the end) ÷ 2. It smooths out the effect of profits, buybacks and new shares during the year.

The DuPont analysis: the three parts of ROE

The DuPont analysis, named after the company that popularized it, splits ROE into three ratios that multiply back to it. The drawing at the top shows XYZ:

  • Net margin = net income ÷ revenue = 180 ÷ 1,000 = 18%: how much profit each sales dollar brings (profitability).
  • Asset turnover = revenue ÷ total assets = 1,000 ÷ 1,500 ≈ 0.67: how many sales dollars each dollar of assets produces (efficiency).
  • Equity multiplier = total assets ÷ equity = 1,500 ÷ 600 = 2.5: how far the assets are financed by liabilities rather than by shareholders (leverage).
  • Multiply them: 18% × 0.67 × 2.5 ≈ 30%, the same ROE. Revenue and assets cancel out, so the identity always holds; its value is in showing whether margins, efficiency or debt moved when ROE changes.

High ROE from margins vs high ROE from debt

Two companies can show the same ROE for very different reasons. In the drawing below, both hypothetical companies have $1,000 million of revenue and $1,000 million of assets, and both earn a 20% ROE. Company A earns $160 million, a 16% net margin, with $800 million of equity and $200 million of liabilities. Company B earns $40 million, a 4% net margin, with only $200 million of equity and $800 million of liabilities.

A earns its ROE from the business; B earns it from leverage, with assets five times its equity. A small dip in B’s margin can turn its profit into a loss, and its lenders are paid first. Return on assets, net income ÷ total assets, exposes the difference: 16% for A, 4% for B.

Turn your phone sideways to read the drawing. Tap to close.

Two hand-drawn panels, A: ROE from margins and B: ROE from debt. Each has an assets column of 1,000 split into liabilities (pink) on top and shareholders’ equity (yellow) below, beside a green net income bar: A shows liabilities 200, equity 800 and net income 160; B shows liabilities 800, equity 200 and net income 40. Next to each: net margin 16% and 4%, leverage 1.25× and 5.0×, ROE 20% highlighted in both, and ROA 16% and 4%. A key names liabilities, shareholders’ equity and net income, and a note reads same revenue, same assets.

How debt magnifies ROE, in both directions

Debt lets a company run more assets on the same equity, so good years look better and bad years worse. In the drawing below, the same hypothetical business, with $1,000 million of assets, earns an operating profit of $100 million in a good year and $20 million in a bad one, and pays 6% interest on its debt; taxes are left out to keep it simple.

Shrinking equity has the same effect. Stock buybacks and write-downs reduce equity, so ROE rises even if profit does not, and once equity turns negative, ROE stops meaning anything. Check debt-to-equity on the balance sheet whenever an ROE looks unusually high.

  • No debt, equity 1,000: ROE +10% in the good year, +2% in the bad one.
  • Debt 500 (interest 30), equity 500: ROE +14% and −2%.
  • Debt 800 (interest 48), equity 200: ROE +26% and −14%.

Turn your phone sideways to read the drawing. Tap to close.

Hand-drawn pairs of bars around a zero line for one business, with the note same business, more debt: with no debt, ROE +10% in a good year (green) and +2% in a bad year (red); with debt 500, +14% and −2%; with debt 800, +26% and −14%, the red bars dropping below zero.

ROE vs ROA vs ROIC

Return on assets (ROA) = net income ÷ total assets: XYZ’s 180 ÷ 1,500 = 12%. It ignores how the assets are financed, so it compares companies with different debt levels more fairly, but it penalizes businesses that need large assets, and banks, which run mostly on deposits and borrowed money, have low ROAs by nature.

Return on invested capital (ROIC) = after-tax operating profit ÷ (debt + equity), the money investors have put into the business. XYZ: 250 × (1 − 20%) = 200, and 200 ÷ (300 + 600) ≈ 22%. Because it starts from operating profit before interest, it judges the business regardless of how it is financed. Analysts define ROIC in slightly different ways, for example by subtracting cash, so compare companies with the same formula.

What is a good ROE? Compare within a sector and over time

There is no universal good number. Industries differ in margins, assets and debt: a bank’s ROE depends heavily on leverage, while an asset-light software company can post a high ROE with no debt at all. Compare ROE with direct peers and with the company’s own history, measured the same way.

  • Look for an ROE that is high and steady for five years or more, not one good year.
  • Split it with DuPont: margins and turnover are sturdier sources than leverage.
  • Check debt-to-equity and ROA next to ROE, and be careful when equity is tiny or negative.
  • Pair it with valuation: an excellent ROE bought at any price is not a bargain; see valuation ratios and the P/E ratio.