2. Return on Equity (ROE)

ROE indicates how many dollars of net income a firm generates with each dollar of shareholder's equity. Therefore, it is a measure of how efficiently a firm uses the the money from shareholders to generate profits. The most common way to express ROE is to divide Net income by Average book equity equity:

 

\( ROE = \frac{\text{Net income}}{\text{Average book equity}} \).

 

We extract the following information from Hershey's balance sheets and income statement for the year 2015 (in millions of USD):

  • Net income 2015: 513.0
  • Book equity beginning of 2015: 1'519.5
  • Book equity end of 2015: 1'047.5

Hence, the firm's average book equity in 2015 was:

 

Average book equity = \( \frac{\text{Book equity}_{2014}+ \text{Book equity}_{2015}}{2} =\frac{1'519.5+1'047.5}{2} \) = 1'283.5.

 

Consequently, the firm's return on equity was:

 

\( ROE = \frac{\text{Net income}}{\text{Average book equity}} = \frac{513}{1'283.5} \) = 0.4 = 40%.

  

Put differently, for each dollar invested by shareholders in the form of capital or retained earnings, the firm has generated a profit of 40 cents in 2015.

 

Since ROE only considers the capital provided by shareholders, it makes sense to relate that capital to an earnings figure that captures the profits the firm generates for its shareholders. Arguably, net income is an appropriate measure of that profit because, as we have seen, it is computed after all operating expenses, interest expenses, and taxes. 

 

While ROE is highly popular as a profitability measure, we have to be very careful when interpreting that ratios and when comparing it over time and across companies. In particular, a high ROE does not necessarily mean that the shareholders are better of. It could simply mean that their investment is risky. The following main section deals with such considerations in more detail and decomposes ROE into its main value drivers. But let us first look at other profitability measures.