What is ROE (Return on Equity)?

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Return on Equity (ROE) measures how effectively a company uses the money invested by its shareholders to generate profits. In plain language: for every ₹1 of shareholders’ equity, how much profit does the company generate?

Basic formula

ROE=Net IncomeShareholders’ Equity\text{ROE} = \frac{\text{Net Income}}{\text{Shareholders' Equity}}

Expressed as a percentage.
Example: if net income = ₹10,000 and shareholders’ equity = ₹50,000, then:

  1. Divide: 10,000÷50,000=0.2010{,}000 \div 50{,}000 = 0.20.

  2. Convert to percent: 0.20×100=20%0.20 \times 100 = 20\%.
    So ROE = 20%.

Why ROE matters

  • It shows profitability relative to owners’ capital (not total assets).

  • Investors use it to compare how well different companies turn equity into profits.

  • A higher ROE generally indicates more efficient use of equity — but context matters (industry, leverage, one-time items).

DuPont analysis — why break ROE apart?

DuPont decomposition shows why ROE is high or low by splitting it into components. Two common forms:

3-step DuPont

ROE=Profit Margin×Asset Turnover×Equity Multiplier\text{ROE} = \text{Profit Margin} \times \text{Asset Turnover} \times \text{Equity Multiplier}

Where:

  • Profit margin = Net Income / Revenue

  • Asset turnover = Revenue / Total Assets

  • Equity multiplier = Total Assets / Shareholders’ Equity (a measure of financial leverage)

Numeric example
Suppose:

  • Revenue = ₹100,000

  • Net income = ₹10,000 → Profit margin = 10,000/100,000=0.1010{,}000/100{,}000 = 0.10 (10%)

  • Total assets = ₹200,000 → Asset turnover = 100,000/200,000=0.5100{,}000/200{,}000 = 0.5

  • Equity = ₹50,000 → Equity multiplier = 200,000/50,000=4200{,}000/50{,}000 = 4

Multiply: 0.10×0.5×4=0.200.10 \times 0.5 \times 4 = 0.20 → ROE = 20% (matches earlier).

5-step DuPont (more granular)

ROE=Net IncomeEBT⏟Tax burden×EBTEBIT⏟Interest burden×EBITRevenue⏟EBIT margin×RevenueAssets⏟Asset turnover×AssetsEquity⏟Equity multiplier\text{ROE} = \underbrace{\frac{\text{Net Income}}{\text{EBT}}}_{\text{Tax burden}} \times \underbrace{\frac{\text{EBT}}{\text{EBIT}}}_{\text{Interest burden}} \times \underbrace{\frac{\text{EBIT}}{\text{Revenue}}}_{\text{EBIT margin}} \times \underbrace{\frac{\text{Revenue}}{\text{Assets}}}_{\text{Asset turnover}} \times \underbrace{\frac{\text{Assets}}{\text{Equity}}}_{\text{Equity multiplier}}

Using numbers:

  • EBIT = ₹15,000

  • Interest = ₹2,000 → EBT = EBIT − Interest = ₹13,000

  • Tax = ₹3,000 → Net income = ₹10,000

Compute components:

  • Tax burden = Net income / EBT = 10,000/13,000≈0.7692310{,}000/13{,}000 \approx 0.76923

  • Interest burden = EBT / EBIT = 13,000/15,000≈0.8666713{,}000/15{,}000 \approx 0.86667

  • EBIT margin = 15,000/100,000=0.1515{,}000/100{,}000 = 0.15

  • Asset turnover = 100,000/200,000=0.5100{,}000/200{,}000 = 0.5

  • Equity multiplier = 200,000/50,000=4200{,}000/50{,}000 = 4

Multiply: 0.76923×0.86667×0.15×0.5×4=0.200.76923 \times 0.86667 \times 0.15 \times 0.5 \times 4 = 0.20 → ROE = 20%.

This decomposition helps identify whether ROE is high because of operational strength (margin, turnover) or because of leverage (equity multiplier).

Interpretation — good vs bad ROE

  • Higher ROE is generally better, but why it’s high matters:

    • High due to strong margins and turnover → usually healthy.

    • High due to high leverage (big equity multiplier) → riskier; debt magnifies profits but also losses.

  • Compare within industry: Capital-intensive industries (utilities, banks) typically have different typical ROEs than software or consumer goods.

  • Look at trend: rising ROE from improved operations is better than rising ROE from taking on lots of debt.

Limitations & pitfalls

  • Leverage distortion: Debt can boost ROE even as risk rises.

  • Negative or tiny equity: If shareholder equity is negative or very small, ROE is meaningless or extreme.

  • One-time gains: Extraordinary items, asset sales, tax credits can spike net income and ROE temporarily.

  • Accounting differences: Buybacks reduce equity and can mechanically raise ROE even without real performance improvement.

  • Use of averages: Best practice is to use average shareholders’ equity over the period (opening + closing equity)/2, not just year-end equity.

Variants and related metrics

  • ROCE (Return on Capital Employed) and ROA (Return on Assets) — useful complements; ROCE includes debt capital, ROA relates to total asset efficiency.

  • ROTE / ROTCE (Return on Tangible Common Equity) — removes intangible assets (good for banks/tech with big goodwill).

  • Adjusted ROE — excluding one-off items to see recurring profitability.

How investors and managers use ROE

  • Investors: screen companies (consistent, industry-leading ROE is attractive) and check sustainability of ROE (is it operational or debt-driven?).

  • Managers: improve ROE by increasing net income (higher margin, sales growth, cost control) or optimizing capital structure (buybacks, lower equity), but must balance risk.

Quick checklist when you see an ROE number

  1. Compare to industry peers.

  2. Check trend (3–5 years).

  3. Inspect components (DuPont): margin, turnover, leverage.

  4. Check for one-offs, accounting changes, recent buybacks or large debt moves.

  5. Use average equity for yield calculations.

  6. If equity is negative or tiny, treat ROE as unreliable.

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