Divide period net income by average beginning and ending shareholders’ equity.
Earnings on average shareholders’ equity
Return on equity divides net income for a period by average beginning and ending shareholders’ equity. The two balance-sheet dates should bracket the income period. This page does not split the result into DuPont margins, turnover, and leverage. ROI is project profit over cost. Gordon growth values a dividend stream. High ROE can come from leverage; compare it with debt-to-equity.
Average equity = (beginning equity + ending equity) ÷ 2 ROE = period net income ÷ average equity
Example
$5,000,000 of net income with $35,000,000 beginning equity and $45,000,000 ending equity has $40,000,000 average equity and 12.5% ROE. OpenStax’s $35,000 net income with $90,000 beginning and $100,000 ending equity has $95,000 average equity and about 36.84% ROE.
What this ratio leaves out
Both equity balances must be positive. Negative book equity, preferred dividends and ownership changes can require a more detailed analysis. A loss produces negative ROE. Use net income and equity dates from the same reporting period.
Frequently asked questions
Why use average equity?
Net income covers a period while each balance sheet is a point-in-time snapshot. Averaging beginning and ending equity aligns the denominator more closely with that period.
Can net income be negative?
Yes. Then ROE is negative.
How is this different from ROI?
ROI divides a project’s profit by its cost. ROE divides a firm’s period net income by average shareholders’ equity.
Does high ROE mean a cheap stock?
No. Leverage can raise ROE without raising asset returns. Gordon growth and CAPM are valuation identities, not this ratio.