Return on Average Equity
Return on Average Equity (ROAE) is a financial metric that measures a company’s profitability by comparing its net income to its average shareholders’ equity during a specified period. It essentially gauges how well a company is using shareholders’ equity to generate profit.
The formula for ROAE is:
ROAE = Net Income / Average Shareholders’ Equity
Where:
- Net Income is the company’s total profit for the period after all expenses and taxes have been deducted.
- Average Shareholders’ Equity is computed by adding the beginning and ending shareholders’ equity for the period, then dividing by two.
ROAE is expressed as a percentage. A higher ROAE indicates that the company is effectively using the equity invested by its shareholders to generate profits.
Example of the Return on Average Equity
Let’s delve into a fictional example to illustrate the concept of Return on Average Equity (ROAE).
Example: GreenTech Innovations
GreenTech Innovations is a fictional startup specializing in green technology solutions. We want to measure how well they are generating profit with the equity provided by the shareholders in the year 2023.
Given Data:
- Net Income for 2023: $3 million
- Shareholders’ Equity at the start of 2023: $15 million
- Shareholders’ Equity at the end of 2023: $19 million
Step 1: Calculate Average Shareholders’ Equity
Average Shareholders’ Equity = (Beginning Shareholders’ Equity + Ending Shareholders’ Equity) / 2
Average Shareholders’ Equity = ($15 million + $19 million) / 2
Average Shareholders’ Equity = $17 million
Step 2: Calculate ROAE
ROAE = Net Income / Average Shareholders’ Equity
ROAE = $3 million / $17 million
ROAE=0.1765
Convert to percentage: 0.1765 × 100 = 17.65
Thus, GreenTech Innovations’ ROAE for 2023 is 17.65%.
Interpretation:
For 2023, GreenTech Innovations was able to generate a return of 17.65% on its average equity. This means that for every dollar of equity invested by shareholders, the company produced a net profit of approximately 17.65 cents. Stakeholders, especially investors, would evaluate this metric to understand how effectively the company’s management is employing their capital to generate earnings. Comparing GreenTech’s ROAE to other companies in the green tech sector would offer further context on its performance.
