What it means
Shareholders put money into a company and expect a return on it. ROAE measures that return by dividing net income by the average of the opening and closing shareholders' equity.
Using the average instead of a single date avoids distortion when equity changes during the year through new share issues, buybacks or large profits. A higher ROAE generally means the company is using shareholders' money efficiently.
For example, 15% suggests that each $100 of shareholders' funds produced $15 of profit in the year. Investors compare this figure with the return they could earn elsewhere and with competitors in the same industry.
Banks and insurers watch ROAE closely, as do companies that report to investors in competitive sectors. Boards often link executive bonuses to a target ROAE.
When used in this way, it is important to understand what is driving the number. Three levers sit behind ROAE: how profitable each dollar of sales is, how efficiently assets generate sales, and how much debt funds the assets.
The DuPont breakdown shows that ROAE equals ROAA multiplied by the equity multiplier, which is average assets divided by average equity. The nuance is leverage.
A company can raise ROAE simply by borrowing more and shrinking its equity, which makes returns look better while making the business riskier. Wise readers always check debt levels alongside the ratio.
Because equity is the shareholders' cushion, a very low or falling equity base can make ROAE jump for the wrong reasons. Analysts therefore compare ROAE with the capital ratios that regulators and lenders watch.
A balanced view looks at both the return and the buffer behind it.
In practice
Real-world examples.
Example
A listed bank reports ROAE of 11% and its board target is 12%. The chief executive explains that a slowdown in lending and higher funding costs held profits back.
Example
A private equity fund compares two portfolio companies. One produces ROAE of 18% with little debt, while the other produces 22% but is funded mostly by loans, so the fund views the second as riskier.
Example
A family-owned manufacturer calculates ROAE to decide between reinvesting profits and paying a dividend. With ROAE of 9% versus a savings return of 4% after tax, the owners choose to reinvest.
Formula
Calculation
ROAE = Net Income (available to ordinary shareholders) / Average Shareholders' Equity
Average Equity = (Opening Equity + Closing Equity) / 2
Worked example: A company earns net income of $1,500,000. Shareholders' equity was $11,000,000 at the start of the year and $13,000,000 at the end.
Average equity = ($11,000,000 + $13,000,000) / 2 = $24,000,000 / 2 = $12,000,000
ROAE = $1,500,000 / $12,000,000 = 0.125 = 12.5%
Link to ROAA: if average total assets were $100,000,000, ROAA = $1,500,000 / $100,000,000 = 1.5% and the equity multiplier = $100,000,000 / $12,000,000 = 8.33, so ROAE = 1.5% x 8.33 = 12.5%, which matches.
Now suppose the company had borrowed more and cut average equity to $10,000,000 while earning the same $1,500,000. ROAE would be $1,500,000 / $10,000,000 = 15%, a higher figure with no improvement in profit, which shows how leverage flatters the ratio.Case study
Seen in the real world.
Beacon Insurance is a fictional insurer that reported net income of $30 million on average equity of $300 million, an ROAE of 10%. In this illustrative case, the chief executive set a target of 15% and linked executive bonuses to it.
Within a year, management reached 15% by returning $100 million of capital to shareholders through a buyback, which cut average equity to $200 million without increasing profit: $30 million / $200 million = 15%. The ratio improved, but the company's capital cushion shrank.
The board then asked that bonus targets also include a capital adequacy measure. This ensured that ROAE gains came from improved profitability and not just from a thinner buffer against losses. Looking back, the chief executive admitted that the target had pushed the team toward the easiest way of lifting the ratio. A fairer plan would have rewarded growth in net income and sound capital together, and the next year's plan was written that way.
Watch out
Common mistakes.
- Celebrating a rising ROAE without checking why. It can climb because equity shrinks or debt increases, not because the business improves.
- Including preferred dividends in the profit figure. Net income should be reduced by preferred dividends so that it reflects returns to ordinary shareholders.
- Comparing negative equity companies. When equity is negative or near zero, the ratio becomes meaningless.
Questions
People also ask.
What is the difference between ROAE and ROE?
ROE may use year-end equity, whereas ROAE specifically uses the average of opening and closing equity.
What is a good ROAE?
It depends on the industry, but many investors look for returns above the company's cost of equity. If shareholders require 10% and the company earns 8%, it is destroying value despite reporting a profit.
How does ROAE connect to ROAA?
ROAE equals ROAA multiplied by the equity multiplier, so leverage links the two.
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