Return on equity = Net income ÷ Avg. shareholder equity
Return on equity is also known as ROE and the formula above helps analysts to understand the earning ability of a company. Stockholders also use ROE formula along with other equations to determine the earning potential of investment.
What is avg. shareholder equity in ROE formula
As you can see the formula we discuss earlier contains a value for average shareholders’ equity in denominator. One can find the stockholders equity from the balance sheet of a company, by adding opening and closing balance of equity and dividing by two avg. shareholder equity can be calculated.
To calculate stockholder equity, use the formula below;
Stockholder equity = Assets – Liabilities
For calculating avg. shareholder equity one can find the opening assets and opening liabilities from balance sheet to get the opening stockholder equity. On the other side, use closing assets and closing liabilities to calculate closing shareholder equity. Shareholder equity is also commonly known as net assets.
ROE vs. return on assets – How both are useful?
Return on assets and return on equity are quite similar by name but there is a little difference in the approach of calculation. However, sometime little things can bring huge change and especially if we talk about little calculation errors which are entirely destroy decision making.
The value in denominator of ROE formula contains avg. shareholder equity while on the other side return on assets formula contains avg. total assets. Therefore, there is a huge difference in calculation techniques and so are the results. The calculation technique for average of both formulas is same as we discuss earlier and can be found from balance sheet of a company.
Although assets reported on balance sheet are calculated by adding stockholder’s equity and liabilities but ROE don’t use liabilities. While on the other side ROE also use the same technique however, return on equity formula does not use liabilities to calculate the values.
The return on equity can be useful both for internal and external purpose. One can use ROE with capital yield, total stock return, dividend yield and others.
Return on Equity formula alternative
There is another way also where you can calculate ROE;
ROE = Profit margin × Equity multiplier × Asset turnover
If we look in to all above formulas separately then multiply all of them with each other. We will get the following equation in result;
ROE = [Net income ÷ net sales] × [Total assets ÷ shareholder equity] × [Net sales ÷ total assets]
ROE = Net income ÷ shareholder equity
The result we get above is the same formula which is available on the top of this page. However, we can use both formulas according to your convenience.