Return on Equity (ROE)

What is return on equity?

Return on equity (German: Eigenkapitalrentabilität, also Eigenkapitalrendite; abbreviated ROE) denotes the ratio of net income for the year to the average equity of a period, expressed as a percentage. Net income for the year is profit after interest and taxes. Equity is the capital that the shareholders have paid in or left in the company as profit. The key figure states how this capital has earned a return in the company according to the balance sheet.

If someone puts EUR 50,000 of their own money into a beverage wholesaler and EUR 5,000 of profit remains per year after all costs, interest and taxes, the investment earns a return of 10%. This can be compared with the interest on a savings account, at a considerably higher risk.

Return on equity belongs to classic balance sheet analysis and to the profitability comparison of companies with a positive result. It matters above all for established companies and in the choice between equity and debt financing. It is also used in debt-financed takeovers by financial investors, who buy companies in order to resell them after a few years, and in business succession. For technology companies before reaching break-even, it carries hardly any meaning.

Calculating return on equity: formula and variants

Formula: Return on equity = net income for the year / average equity × 100%

Average equity is usually formed as the mean of the opening and closing balance of the period. This softens distortions, for example by a capital increase shortly before the balance sheet date or by the net income for the year itself, which already raises equity at year end.

The pre-tax variant uses the result before income taxes and is suitable for comparisons between companies with different tax burdens. The denominator is generally balance sheet equity. The ROI system of key figures (Return on Investment) breaks returns down into their components. On this basis, return on equity results as the product of three factors: return on sales (profit per euro of revenue), capital turnover (revenue divided by total capital) and total capital divided by equity.

Leverage effect and its risk

The leverage effect describes how the use of debt capital, that is, loans and other debts, changes return on equity. Before taxes, the following applies:

Formula: Return on equity = return on total capital + (return on total capital - cost of debt) × debt capital / equity

Return on total capital here is the result before interest and taxes in relation to total capital, and the cost of debt is the average interest rate on debt capital. If return on total capital is above the interest rate on debt, additional debt capital raises the shareholders' return. The gap between the two rates is multiplied by the static debt ratio, that is, the ratio of debt capital to equity. If return on total capital is below the interest rate on debt, the effect reverses, and return on equity falls below return on total capital.

Leverage amplifies fluctuations in results in both directions. The formula does not show some risks. The interest rate on debt generally rises with increasing debt, interest and repayment must be paid regardless of the result, and loan agreements attach termination rights to debt ratios. A high return on equity that rests on high debt must therefore always be assessed together with the equity ratio and the debt service capacity. The latter describes whether interest and repayment can be paid from the ongoing business.

Interpretation: meaning depending on the company's phase

With losses, the key figure is negative and merely describes how quickly equity is being consumed. If equity itself is negative, the division loses all meaning; a net loss for the year divided by negative equity would even produce an arithmetically positive return.

Return on equity becomes relevant as soon as a company earns sustainable profits. In takeovers by financial investors, the leverage effect is the core of the return logic: part of the purchase price is financed with debt that is serviced from the cash surpluses (cash flows) of the acquired company. In business succession, the key figure helps with the question of whether a management buy-out, the purchase by the company's own management, can be financed sustainably from the existing result.

Worked example: return on equity and leverage effect

An established service company deploys total capital of EUR 10.0 million that does not change over the year. It achieves a result before interest and taxes of EUR 1.2 million, that is, a return on total capital of 12%. Debt capital costs 6% interest. Two financing variants are compared, all values before taxes. Variant A works with EUR 8.0 million of equity and EUR 2.0 million of debt capital, variant B with EUR 3.0 million of equity and EUR 7.0 million of debt capital.

• Variant A: interest 2.0 × 6% = EUR 0.12 million, result 1.2 minus 0.12 = EUR 1.08 million, return on equity 1.08 / 8.0 = 13.5%
• Check using the formula for A: 12% + (12% - 6%) × 2.0 / 8.0 = 12% + 1.5% = 13.5%
• Variant B: interest 7.0 × 6% = EUR 0.42 million, result 1.2 minus 0.42 = EUR 0.78 million, return on equity 0.78 / 3.0 = 26%
• Check using the formula for B: 12% + (12% - 6%) × 7.0 / 3.0 = 12% + 14% = 26%
• Fall in the result before interest and taxes to EUR 0.4 million (return on total capital 4%), variant A: 0.4 minus 0.12 = EUR 0.28 million, return on equity 3.5%
• Same fall, variant B: 0.4 minus 0.42 = minus EUR 0.02 million, return on equity about minus 0.7%

In the good year, the higher debt almost doubles the shareholders' return. In the weak year, the result in variant B no longer covers the interest, while variant A still reports a profit. In practice, a lender demands a higher interest rate for variant B. That reduces the advantage in the good year and enlarges the disadvantage in the weak one.

Distinctions: return on total capital, equity ratio and IRR

• Investor returns: The internal rate of return (IRR) and the multiple on invested capital measure what an investor earns on the price actually paid. Both take account of distributions and the sale proceeds. They depend on entry and exit valuation and are not the return on equity of the company, which relates to book capital.
• Return on total capital: return on all capital employed, regardless of financing; the starting point of the leverage effect.
• Equity ratio: the share of equity in total assets. It describes the stability of the financing, return on equity its yield.

Common mistakes

• Closing balance instead of average. Anyone who divides net income for the year by the equity at year end, which already contains this income, reports too low a return.
• Key figure calculated with negative equity. The result is arithmetically possible but has no substantive meaning.
• Leverage considered without risk. A return raised by debt capital conceals the greater vulnerability to falls in results and rising interest rates.
• Book return confused with investor return. A return on equity of 20% does not mean that an investor who came in at a high premium earns 20% on the purchase price.

Frequently asked questions

How is return on equity calculated?

As net income for the year divided by average equity times 100. An example: net income for the year EUR 600,000, equity of EUR 3.7 million at the start of the year and EUR 4.3 million at year end. The average is EUR 4.0 million, return on equity 15%; calculated with the closing balance, it would be only about 14%.

What is a good return on equity?

One that is permanently above the cost of equity, that is, above the return that shareholders expect for the risk taken. There is no universal benchmark. Because of the higher risk, the cost of equity is generally above the interest rate on debt capital. A high value that rests mainly on debt is less reliable than the same value with a solid equity ratio.

How can return on equity be increased?

Through three levers of the ROI system of key figures: a higher return on sales, a higher capital turnover or more debt capital in relation to equity. The first two improve earning power. The third route works only as long as return on total capital is above the interest rate on debt, and at the same time raises risk.

Why is the key figure of little meaning for young technology companies?

Because losses and high capital reserves distort it. As long as a company makes losses, the return is negative, and equity mainly reflects the investors' payments, not the value of the company.

Does a profit distribution raise return on equity?

Arithmetically yes in the following periods, because equity falls while the result initially stays the same. Nothing changes in the company's earning power as a result, and the equity ratio falls.

How are return on equity and purchase price related in a management buy-out?

Through financeability. The more debt capital the company's result can service, the lower the buyers' equity share and the higher their expected return. That widens the scope on the purchase price but raises the risk of the takeover.

The Roemer Capital view

In succession mandates and in sales to financial investors, Roemer Capital calculates which financing structure an acquirer needs for the purchase price offered and what return on equity the acquirer can expect from it. This helps sellers to assess whether an offer is financeable or is likely to come under pressure later.

For growth companies in funding rounds, by contrast, the key figure plays hardly any role in Roemer Capital's work. There, Roemer Capital talks with investors about growth, unit economics and runway. In doing so, Roemer Capital explains why an investor's return expectation is tied to the entry price and the later proceeds and not to the company's book capital.