Alright, let's talk about something that used to confuse the heck out of me when I first started investing: return on equity. You've probably seen ROE mentioned everywhere – in annual reports, stock analysis sites, those fancy investor presentations. But when I tried to figure out how to work out return on equity myself, I found most explanations were either too technical or suspiciously oversimplified.
I remember staring at a company's balance sheet in 2018, calculator in hand, completely baffled about which numbers to use. Was I supposed to use year-end equity? Average equity? And what about those preferred dividends everyone keeps mentioning? That confusion cost me some decent investment opportunities, honestly.
Today we're fixing that. We're digging into exactly how to work out return on equity without the finance jargon overdose. This is the guide I wish I'd had when I started.
What Exactly is Return on Equity?
ROE tells you how efficiently a company uses shareholder money to generate profits. Think of it this way: if you and three buddies pool $100,000 to start a burger joint, ROE measures how much profit that $100,000 is producing.
Why should you care? Well, early in my investing journey, I got seduced by companies with flashy revenue growth. Big mistake. I learned the hard way that companies with high ROE tend to be better at turning capital into profits. Take it from me – understanding how to work out return on equity helps you spot the real money-makers.
The Naked ROE Formula
Here's the basic equation everyone throws around:
Looks simple, right? But when I first tried applying this, I discovered three places where people mess up:
Watch your time periods: Mixing quarterly income with annual equity? Disaster. Always use matching time frames.
Preferred dividends trip people up: If a company has preferred stock, you MUST subtract those dividends from net income first. I learned this after misjudging a REIT's performance.
Equity isn't always straightforward: That clean "shareholders' equity" line? Sometimes it includes items that distort ROE. We'll talk about adjustments later.
Where to Find the Ingredients
Let's get practical. Where do you actually find these numbers?
| Component | Where to Find It | Pro Tip |
|---|---|---|
| Net Income | Income Statement (bottom line) | Use net income attributable to common shareholders if available |
| Shareholders' Equity | Balance Sheet | Check for "Total Shareholders' Equity" or equivalent |
I made the rookie mistake of pulling numbers from different reports once. The income statement was full-year but I grabbed quarter-end equity. My ROE calculation was wildly off. Don't be like past me.
The Step-by-Step ROE Calculation Process
Let's walk through how to work out return on equity with a real example. We'll use Apple's 2023 numbers because everyone knows them:
Step 1: Get the Correct Net Income
For Apple FY2023 (ended Sept 30):
Net Income = $97 billion
Important: Apple doesn't have preferred dividends, so no adjustment needed. If they did, we'd subtract those first.
Step 2: Determine Shareholders' Equity
Here's where things get interesting. You've got options:
- Year-end method: Just grab the Sept 30, 2023 equity: $62.15 billion
- Average equity method: (Equity at start + Equity at end)/2
Which is better? Frankly, average equity usually gives a more accurate picture, especially if the company did stock buybacks or issued new shares during the year.
Step 3: Calculate ROE
Year-end method: ROE = $97B / $62.15B = 156%
Average method:
Start equity (Sept 2022): $50.67B
End equity (Sept 2023): $62.15B
Average equity = ($50.67B + $62.15B)/2 = $56.41B
ROE = $97B / $56.41B = 172%
See the difference? 156% vs 172% - that's why methodology matters.
When I first saw Apple's ROE over 150%, I thought it was a typo. But their massive buyback program reduces equity, boosting ROE. This brings us to...
Why ROE Can Mislead You (and How to Fix It)
High ROE doesn't automatically mean a great company. Here are three ways ROE can deceive you - all learned through painful experience:
| ROE Distortion | Why It Happens | How to Adjust |
|---|---|---|
| Debt Illusion | Companies load up on debt, shrinking equity. ROE looks amazing but risk is high | Check debt-to-equity ratio alongside ROE |
| Buyback Boost | Share repurchases reduce equity, artificially inflating ROE | Look at ROE trend before/after buybacks |
| Asset Light Trap | Tech firms may have high ROE naturally due to low asset needs | Compare to industry peers only |
I got burned by a retailer showing 25% ROE. Looked great until I realized it was all debt-fueled. They filed for bankruptcy eighteen months later.
The DuPont Analysis Fix
This is where DuPont analysis saves you. It breaks ROE into three components:
Translation:
- Profit Margin: How much profit from each dollar of sales?
- Asset Turnover: How efficiently assets generate sales?
- Equity Multiplier: How much debt is being used?
Let's revisit Apple using DuPont (2023 data):
| Component | Calculation | Value |
|---|---|---|
| Net Profit Margin | Net Income / Revenue | $97B / $383B = 25.3% |
| Asset Turnover | Revenue / Total Assets | $383B / $352B = 1.09x |
| Equity Multiplier | Total Assets / Equity | $352B / $62B = 5.68x |
ROE = 25.3% × 1.09 × 5.68 = 156%
Now you see the leverage effect! Without that 5.68x multiplier, ROE would be around 27.6%. Debt magnifies returns – for better or worse.
When ROE Calculation Gets Messy
Textbook examples never show the messy realities. Here are situations where figuring out how to work out return on equity requires extra steps:
Negative Equity Situations
When shareholders' equity is negative (yes, that happens), ROE is meaningless. I once analyzed a turnaround company with -$2B equity. Calculating ROE would've produced a negative percentage that told me nothing useful. In these cases, look at return on assets (ROA) instead.
Seasonal Businesses
For companies with wild seasonal swings – like retailers doing 40% of sales in Q4 – use trailing twelve-month (TTM) net income rather than annual. Your equity should still be averaged, but match it to the TTM period.
Banking and Insurance Companies
These are special cases. Banks naturally carry huge debt, making ROE potentially misleading. Insurance companies have float that distorts equity. For these, analysts often use:
- Return on tangible equity (ROTE)
- Return on risk-weighted assets (for banks)
ROE Benchmarks: What's a Good Number?
People always ask: "What's a good ROE?" Annoyingly, the answer is: "It depends." But here's a rough guide based on sectors:
| Industry | Typical ROE Range | Exceptional ROE |
|---|---|---|
| Technology | 15-25% | 30%+ |
| Healthcare | 12-20% | 25%+ |
| Consumer Goods | 18-30% | 40%+ |
| Utilities | 8-12% | 15%+ |
| Banks | 9-13% | 15%+ |
But honestly? Comparing ROE across industries is like comparing apples to bulldozers. A 10% ROE might be stellar for a utility but terrible for a software company.
The smarter approach: compare a company to its historical ROE and direct competitors. If Coca-Cola's ROE is 40% while Pepsi is at 50%, that tells you more than absolute numbers.
My ROE Calculation Checklist
After years of trial and error, here's my personal checklist when working out return on equity:
- ☑ Used net income to common shareholders? (adjusted for preferred dividends)
- ☑ Used average equity? (unless valid reason not to)
- ☑ Checked for negative equity? (switch to ROA if negative)
- ☑ Verified time periods match?
- ☑ Looked at 5-year trend, not just current year?
- ☑ Performed DuPont analysis?
- ☑ Compared to 3 closest competitors?
This takes maybe 15 extra minutes but prevents embarrassing analysis mistakes. Trust me, I've skipped steps and regretted it.
Common ROE Questions Answered
Why does my calculated ROE disagree with Yahoo Finance?
Probably because they're using different methods. Some services use year-end equity instead of average. Some adjust for extraordinary items. Always calculate it yourself for serious analysis.
Can ROE be too high?
Absolutely. Anything consistently above 50% makes me suspicious. Could signal excessive leverage or accounting tricks. Remember Enron's ROE before collapse? 65%+.
Should I use GAAP or non-GAAP earnings?
For comparability, I stick with GAAP net income. Non-GAAP can be manipulated. Those "adjusted EBITDA" numbers sometimes exclude real expenses.
How often should I calculate ROE?
For active monitoring, quarterly is fine – but use rolling twelve-month data. Annual is sufficient for long-term investors. I update my core holdings' ROE quarterly.
Is ROE useful for all companies?
Not equally. It's most valuable for:
- Banks and financials
- Asset-heavy businesses
- Companies with stable capital structures
Less useful for startups or biotechs with volatile earnings.
Putting ROE to Work in Your Investment Decisions
Here's how I actually use ROE in my stock analysis:
Screening: I look for companies with ROE > 15% for the past 5 years. Filters out weak performers quickly.
Trend Analysis: Is ROE improving or declining? A rising trend beats a single high reading. I passed on a stock with 25% ROE last year because it had dropped from 38% three years prior.
Red Flags: If ROE suddenly spikes without corresponding profit growth, I dig into leverage. Often means they took on dangerous debt.
Management Evaluation CEOs love talking about ROE in earnings calls. When they avoid it? That tells you something.
The biggest lesson? ROE shouldn't be used alone. Pair it with:
- Free cash flow yield
- Debt-to-equity ratio
- Revenue growth
One of my best investments came from spotting a company with mediocre 12% ROE but skyrocketing cash flow growth. Bought at $22, sold at $107.
Final Thoughts
Learning how to work out return on equity properly changed my investing results. It stopped me from chasing flashy growth stocks with weak profitability. But remember - no single metric tells the whole story.
The magic happens when you combine ROE with other analysis. It's like cooking: ROE is your salt. Essential, but you need other ingredients for a great meal.
Start applying this today. Grab a company you're interested in and work through the steps. Calculate it both ways - average equity and year-end. Do the DuPont breakdown. Compare to three competitors. You'll see things most investors miss.
And if you get stuck? Remember my burger joint example. At its core, ROE just answers: "How well are they turning my investment dollars into profits?" Everything else is refinement.
Comment