Return on Stockholders' Equity

Return on stockholders' equity is a profitability ratio that compares a corporation's net income with the equity its shareholders have invested and left in the business. It answers a simple question for owners: how much profit did management generate with our money this year? The ratio is usually expressed as a percentage and is one of the most widely quoted measures of corporate performance.

The general measure is often shortened to return on equity (ROE), which has its own entry. This entry looks at the textbook accounting version used in financial statement analysis, which focuses on the return earned for common stockholders, uses average rather than year-end equity, and is broken down to show what drives it.

The version used in most accounting textbooks is:

• $\text{Net income}$ is profit after tax for the year.
• $\text{Preferred dividends}$ are dividends declared on preferred stock, or the annual cumulative amount owed even if not declared, because that portion of profit belongs to preferred holders.
• $\text{Average common stockholders' equity}$ is total stockholders' equity less the preferred stock's share, averaged between the start and end of the year.

Using an average matters because net income is earned over the whole year while equity changes during it, through profits, dividends, share issues and buybacks.

A manufacturer reports net income of $3,400,000 and pays preferred dividends of $200,000. Total stockholders' equity is $22,000,000 at the start of the year and $26,000,000 at the end, including $2,000,000 of preferred stock both times. Common equity is therefore $20,000,000 at the start and $24,000,000 at the end, an average of $22,000,000.

Return on common stockholders' equity is $3,400,000 minus $200,000, divided by $22,000,000, or about 14.5 percent. A simpler calculation using total year-end equity, $3,400,000 divided by $26,000,000, would give about 13.1 percent, which understates the return available to common shareholders.

The DuPont analysis breaks the ratio into three parts: profit margin (net income divided by sales), asset turnover (sales divided by assets), and the equity multiplier (assets divided by equity). The first two together give return on assets. The equity multiplier reflects financial leverage: the more a company finances itself with debt, the less equity supports each dollar of assets, so the higher the return on equity for a given return on assets. If the manufacturer above earns 7 percent on assets and has an equity multiplier of 2, its return on equity is about 14 percent; with a multiplier of 3 it would be about 21 percent, but with greater risk.

Investors compare the ratio with the company's cost of equity, often estimated at 8 to 12 percent for established US companies. A return consistently above that cost suggests management is creating value for owners. The ratio links directly to growth: a company that earns 15 percent on equity and retains 60 percent of its profits can, in principle, grow its equity by about 9 percent a year without raising new capital.

The ratio has well-known pitfalls. High leverage can inflate it while making the company more fragile, so it should be read alongside the debt-to-equity ratio. Share buybacks shrink equity and can raise the ratio without any improvement in profit. Large write-offs or accumulated losses can make equity very small or even negative, as with negative equity, producing meaningless results. One-off gains also distort it, which is why analysts often recalculate it using adjusted earnings. Comparisons work best within the same industry, since banks, utilities and software firms have very different typical levels.