A company funds its business using either debt or equity. Liabilities on a company’s balance sheet represent creditors’ claims on the company, while stockholders’ equity represents stockholders’ stake. You can calculate a company’s return on equity to measure how much net income, or profit, it generates for every dollar of equity financing it has. ROE equals net income divided by average stockholders’ equity and is expressed as a percentage. A high percentage indicates that management uses stockholders’ capital efficiently, but a percentage that is too high might be a result of abnormally low equity and too much debt.
Locate a company’s balance sheet in its most recent year’s Form 10-K annual report and in the previous year’s 10-K. You can download a company’s Form 10-Ks from the investor relations section of its website or from the U.S. Securities and Exchange Commission’s online EDGAR database.Step 2
Identify the amount of total stockholders’ equity on each balance sheet.Step 3
Add each amount and divide by 2 to calculate average stockholders’ equity. Balance sheets show amounts only at the end of an accounting period, but stockholders’ equity can fluctuate throughout the period. Average equity is a better estimate of how much equity a company held throughout the year than using equity from only one balance sheet. For example, assume a company had $800 million in stockholders’ equity last year and $600 million the previous year. Add $600 million and $800 million to get $1.4 billion. Divide $1.4 billion by 2 for $700 million in average stockholders’ equity.Step 4
Pull up the company’s income statement from its most recent 10-K and find the amount of its net income listed at the bottom of the statement.Step 5
Divide net income by average stockholders’ equity and multiply by 100 to determine the company’s return on equity as a percentage. In this example, assume the company generated $175 million in net income. Divide $175 million by $700 million to get 0.25. Multiply 0.25 by 100 for a 25 percent ROE. This means it produced profit equal to 25 percent of stockholders’ equity, which is typically a strong ROE for most companies.
- Acceptable ROE levels vary among industries. Compare a company’s ROE with those of others in its industry to gauge an appropriate ROE percentage and to measure its performance relative to competitors.
- If a company’s ROE is much higher or lower than those of its peers, investigate the company’s financials further to determine the reason.