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VMC: What Is Return on Equity?

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Definition of Return on Equity (ROE)

  • ROE is another method to measure the profitability of a company.
  • The ROE divides the net income of a company with the shareholder’s equity.
  • The ROE is expressed as a percentage.
  • The shareholder’s equity is the company’s assets minus the company’s debt.
  • Therefore the ROE is arguably the net return on assets.
  • The ROE, therefore, measures how effectively a company uses its assets to generate profits.
  • The ROE’s in each sector are different; therefore, its important to compare with the companies in the industry.

What is the Formula for ROE?

  • The ROE can be calculated by dividing the Net Income by the Shareholder’s Equity.

Net Income ÷ Shareholder’s Equity

  • The net income can be calculated by subtracting the Revenue by Cost of Goods Sold, Expenses, Depreciation, Amortization, Interest, and Taxes
  • The Average Shareholder’s Equity can be calculated by subtracting the Total Assets by the Total Liabilities 

ROE in Practice 

  • Opac Corporation has a revenue of $50,000,000, and its cost of goods sold is worth $35,000,000.
  • Furthermore, Opac also spends $2,500,000, on salaries, $300,000 on utilities and $120,000 on maintenance costs.
  • The depreciation is $35,000 on the assets that Opac owns. The amortization value is $20,000 and Opac currently pays $5,000,000 in interest. The tax rate is 20%.
  • The total assets are worth $150,000,000, and the total liabilities are worth $80,000,000. What is the ROE?
  • 50,000,000 – 35,000,000 – 2,500,000 – 300,000 – 120,000 – 20,000 – 5,000,000 = $7,060,000
  • 7,060,000 x 0.2 = $1,412,000
  • 7,060,000 – 1,412,000 = $5,648,000
  • Therefore the Net Income is $5,648,000
  • 15,000,000 – 8,000,000 = $7,000,000
  • 5,648,000 ÷ 7,000,000 = 0.08
  • 0.08 x 100 = 8%
  • Therefore the ROE for Opac corporation is 8%

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DISCLAIMER: This content is for information purposes only. It is not intended to be investment advice. Readers should not consider statements made by the author(s) as formal recommendations and should consult their financial advisor before making any investment decisions. While the information provided is believed to be accurate, it may include errors or inaccuracies. The author(s) cannot be held liable for any actions taken as a result of reading this article.

Posted in Valuation Master Class