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Return on Stockholders Equity | Definition Ratio | Calculation

Return on Stockholders Equity

Calculate Return on Stockholders Equity

Return on Equity. An indicator of corporate profitability, widely used by investors as a measure of how a company is using its money. There are two ways of calculating ROE: the traditional formula and the DuPont formula. The traditional approach divides the company's net profit after taxes for the past 12 months by stockholders' equity (adjusted for stock splits). But this fails to account for the effect of borrowed funds, which can magnify the returns posted by even a poorly managed company. An alternative approach, developed by the DuPont Corporation, links return on investment (ROI) to financial leverage (use of debt).

Traditional Formula:

ROE = Net Profit After Taxes ÷ Stockholders' Equity

DuPont Formula:

ROE = ROI x Equity Multiplier
ROE = (Net Profit After Taxes ÷ Total Assets) x (Total Assets ÷ Stockholders' Equity)

For example, using the traditional formula, a company with $18,000 in net profit after taxes and $45,000 in stockholders' equity would have an ROE of 40%. The DuPont formula takes the analysis one step further by factoring in the contribution of borrowed funds. Using the previous example, if the company has total assets of $100,000, then $55,000 of the company's capital is supplied by creditors and its equity multiplier is 2.22.

ROE = ($18,000 ÷ $100,000) x ($100,000 ÷ $45,000)
ROE = 18% x 2.22
ROE = 40%

Note: If the company did not use any borrowed funds, its equity multiplier would be 1.0 and its ROE would equal its ROI.

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Link to This Resource: Return on Stockholders Equity | Definition Ratio | Calculation

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