What Is Return on Average Equity (ROAE)?
Let me explain to you what Return on Average Equity (ROAE) is—it's a financial ratio that measures how well a company performs based on its average shareholders' equity outstanding. You should know that ROAE typically looks at a company's performance over a fiscal year, where the numerator is net income and the denominator is the sum of the equity value at the beginning and end of the year, divided by 2.
ROAE is different from the more common Return on Equity (ROE), which takes net income for the year and divides it by the shareholder equity at the end of the year. That end-of-year figure can be affected by stock sales, dividend payments, and other share dilutions, so ROAE gives you a clearer picture in those cases.
Key Takeaways
- A high ROAE means the company is creating more income for each dollar of stockholders' equity.
- ROAE shows you how a company is making its money, whether through profitability, debt accumulation, or asset sales, for example.
- To discern actual profitability, profit margin is calculated by dividing net income by sales.
- The average asset turnover is a measure of asset efficiency and is calculated by dividing sales by the average total assets.
- The financial leverage, measured as the average assets divided by the average stockholders' equity, is a measure of the firm's debt level.
The Basics of Return On Average Equity (ROAE)
You need to understand the basics here: Return on Equity (ROE), which determines performance, is calculated by dividing net income by the ending shareholders' equity value from the balance sheet. But that equity value can include last-minute stock sales, share buybacks, and dividend payments, meaning ROE might not accurately reflect the business's actual return over the period.
That's where Return on Average Equity (ROAE) comes in—it provides a more accurate depiction of a company's profitability, especially if shareholders' equity has changed a lot during the fiscal year. ROAE is basically an adjusted version of ROE, where you change the denominator to average shareholders' equity. So, instead of dividing net income by the ending equity, you divide it by the sum of the equity at the beginning and end of the year, divided by 2.
You'll find net income on the income statement in the annual report, and stockholders' equity at the bottom of the balance sheet. The income statement covers the whole year, while the balance sheet is just a snapshot, so analysts use an average for balance sheet items like equity. If a business doesn't see big changes in shareholders' equity, you probably don't need to bother with the average—ROE and ROAE will be about the same.
In cases where equity stays steady or changes little, the ROE and ROAE numbers will be identical or very similar.
An Example of ROAE
Here's the key equation you should remember: ROAE = Net Income / Average Stockholders’ Equity.
Take Company XYZ as an example—it starts the year with $1,000,000 in shareholder equity and ends with $1,500,000, thanks to investor investments, giving an average of $1,250,000 for the year. You get these figures from the balance sheets of the prior and current year. During the year, XYZ earns $200,000 in net income, which is on the income statement. Plugging into the equation: $200,000 / $1,250,000 = 16%.
As an investor, you'll want to compare ROE and ROAE across companies in the same sector to see which are more profitable and efficient with shareholder equity. If Company XYZ is stuck below 10% ROAE while Company ABC hits over 20%, you get a clear idea of where your money might perform better.
