When evaluating your business strategy, it’s essential to compare financial metrics and assess their relationships. Ratios help quantify these relationships, and analyzing them provides valuable insights into your company’s profitability, efficiency, and financial health.
A strong business strategy includes understanding how effectively you utilize shareholders’ investments. One way to gauge this is by using a financial ratio known as return on equity, or ROE.
“Ratio analysis gives us a clearer picture of a company’s performance by standardizing performance and therefore allowing us to make comparisons,” says Harvard Business School Professor Suraj Srinivasan, who teaches the online course Strategic Financial Analysis.
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DOWNLOAD NOWWhat Is Return on Equity (ROE)?
Return on equity (ROE) is a financial ratio that indicates how efficiently a business generates profit from its shareholders’ equity. Put simply, it represents how much profit your company makes for every dollar invested by shareholders and the return those investors can expect.
ROE is useful for comparing a company’s profitability over time or against competitors within the same industry. It’s important to note that ROE is calculated using net income and shareholders’ equity over a set period—typically a company’s financial reporting year, known as a fiscal year.
Related: How to Use Profitability and Margin Ratios
How to Calculate Return on Equity (ROE)
Like many financial ratios, the ROE equation starts simply but can be expanded for deeper analysis. According to Strategic Financial Analysis, at its most fundamental level, return on equity is calculated using:
Return on Equity = Net Income / Equity
You can calculate net income by subtracting total expenses from total revenue over the specified time:
Net Income = [Total Revenue - Total Expenses]
Alternatively, net income can be found on a company's income statement, while shareholders' equity is reported on its balance sheet. Keep in mind that income statements reflect financial performance over an entire fiscal year, whereas balance sheets provide a snapshot of a company’s capital structure at a specific point in time.
Since shareholders' equity levels fluctuate over time, calculating ROE using only year-end equity data may not accurately reflect the capital available throughout the year. A more precise approach is to use average total equity over time as your denominator.
According to Strategic Financial Analysis, you could use the following calculation as long as your numbers are linear and don’t fluctuate:
Average Total Equity = (Equity at Beginning of Time Period + Equity at End of Time Period) / 2
Try this approach with multiple data points, such as monthly or quarterly averages, to get a more accurate measure of ROE.
ROE in Action: Intel
To demonstrate ROE in Strategic Financial Analysis, Srinivasan explores several microchip-manufacturing industry leaders, including tech giant Intel. Over fiscal year 2021 (FY21), Intel reported a net income of $19,868 million. At the end of FY21, Intel’s shareholders’ equity was $95,391 million. An initial calculation of Intel’s ROE would be:
FY21 Net Income / FY21 Equity = $19,868 / $95,391 = 20.8 percent
However, a more accurate assessment of ROE adjusts for average total equity over the time in question—in this case, fiscal year 2021 (FY21).
Intel’s shareholder equity at the end of FY20 (beginning of FY21) was $81,038 million. By using the average equity between the beginning and end of FY21, you’ll alter the denominator and, in turn, generate a more accurate ROE:
FY21 Net Income / Avg. FY21 Equity = $19,868 / ($95,391 + $81,038) / 2) = 22.5 percent
An ROE of 22.5 percent provides a more accurate picture of Intel’s return on investment across the entire year by adjusting for average equity for the year.
The DuPont Formula: Decomposing ROE
Strategic Financial Analysis teaches that ROE can be broken down into key components through a process known as decomposing ROE. This allows you to identify several useful metrics known together as the DuPont formula—named after the DuPont Corporation, which popularized it in the early 20th century.
DuPont formula analysis incorporates financial leverage, net profit margin, and asset turnover into your original ROE equation and allows you to dig deeper into your company’s profitability using these three levers. To incorporate these metrics into the ROE equation, you must first decompose it.
Start by incorporating your company assets into the equation:
ROE = Net Income / Equity = Net Income / Assets x Assets / Equity
Since assets are featured in the numerator and denominator, they cancel out. So why include them? As Strategic Financial Analysis explains, doing so allows you to define two additional ratios: return on assets and financial leverage.
Next is the equation for return on assets (ROA), which represents how much profit your organization makes per dollar of assets. This is a valuable metric for assessing operational efficiency.
ROA = Net Income / Assets
ROA differs from ROE because it accounts for all assets—including those financed by equity and debt—while ROE focuses only on shareholder equity. Put simply: ROA measures how efficiently your company generates profit using all of its assets, regardless of how they were financed, whereas ROE shows you how efficiently you’re utilizing just your outside investments.
Financial leverage measures how much your business relies on borrowed funds compared to investor funding. The equation for financial leverage is:
Financial Leverage = Assets / Equity
Since assets, like equity, appear on your company’s balance sheet, it’s best to determine your average assets over the specific analyzed period and then use the average for your ratio.
With these ratios, you can translate your original ROE equation to:
ROE = ROA × Financial Leverage
You can now turn your focus to return on assets and further decompose it by incorporating sales:
ROA = Net Income / Assets = Net Income / Sales x Sales / Assets
This creates the equations for net profit margin and asset turnover.
Net profit margin represents how much profit you make for every dollar in sales after accounting for all expenses accrued in making that sale possible. This is a core indicator of your company’s overall success and can be calculated using the following equation:
Net Profit Margin = Net Income / Sales
Asset turnover shows how much sales revenue is generated per dollar of assets invested in your business. It’s calculated using the following:
Asset Turnover = Sales / Assets
By incorporating these ratios into your original ROE equation, you’ll arrive at the complete DuPont formula, which provides unique insight into your company’s financial workings:
ROE = Net Profit Margin × Asset Turnover × Financial Leverage
“By comparing how the three components of ROE have changed over time for a given company, an analyst can learn how the company is executing its strategy across the dimensions of margin, efficiency, and leverage,” Srinivasan says in Strategic Financial Analysis. “By comparing the components of ROE across different companies, an analyst can better understand how different companies are performing with respect to their strategy execution.
A Deeper Understanding Through ROE Analysis
Calculating return on equity (ROE) helps you and your shareholders assess how well an investment is performing—against competitors and over time. You can gain even more targeted insight into your company’s profitability by further expanding the ROE equation into the DuPont formula and its composite ratios. These tools help you identify key financial drivers, optimize growth, and strategically use resources for profit.
Learn more about ROE through interactive exercises that cement your understanding by taking the online course Strategic Financial Analysis. Real-world business cases bring the material to life, and you can gain access to a global network of engaged professionals through the HBS Online Community.
Do you want to learn essential financial concepts and drive business performance? Explore Strategic Financial Analysis—one of our online finance and accounting courses. To get a jumpstart, download our free Financial Terms Cheat Sheet.
