Return on Equity (ROE): Meaning, Calculations, and Excel Examples

Return on Equity (ROE) Definition: The Return on Equity in corporate finance equals a company’s Net Income in a period, such as 1 year, divided by its average Shareholders’ Equity over that same period; it measures a company’s efficiency in generating after-tax profits based on its Common Equity, or its cumulative, saved-up after-tax earnings + capital issued to shareholders.

This definition may seem almost the same as the one for Return on Assets, and it is quite similar.

Both metrics are important for Balance Sheet-centric companies, such as commercial banks and insurance firms, and both measure efficiency.

The difference is that ROE is all about a company’s Equity, or Total Assets minus Total Liabilities, so it is more relevant specifically for the equity investors or common shareholders.

You can calculate ROE for a company in any industry, but in practice, it is the most useful for 3 types of companies:

1. Commercial Banks – ROE is a key metric that determines banks’ overall efficiency and is highly correlated with the P / BV valuation multiple.
2. Insurance Firms – Same, as the business model is similar.
3. Regulated Utility Companies – Here, ROE is a key driver in financial models and determines the rates that utility companies can charge for electricity, gas, and water.

In the first two cases, within a set of comparable public companies, firms with higher ROEs should trade at higher P / BV multiples.

In the third case, the ROE is determined by government regulators, and the company must operate based on that restriction, so ROE becomes a key input in financial models.

Files & Resources:

Return on Equity (ROE) – Presentation Slides (PDF)

Return on Equity (ROE) for Banks and Regulated Utility Companies (XL)

MGE Energy – Full 10-K with Highlights (PDF)

MGE Energy – Key Excerpts from the 10-K (PDF)

Video Table of Contents:

0:00: Introduction

4:36: Part 1: Why ROE for Banks and Insurance?

5:35: Part 2: ROE for Banks (JPM, Citi, Wells, and BofA)

7:42: Part 3: ROE for Utilities (MGE Energy)

11:40: Recap and Summary

Why Does Return on Equity (ROE) Matter So Much for Banks?

Return on Equity is far more significant in the financial sector because many of these companies generate revenue and profits based directly on their Balance Sheets:

• Loans are a key driver in all bank models, but a bank cannot just grow its Loans at arbitrary rates.
• The more Loans a bank has, the more in “regulatory capital” (Shareholders’ Equity) it needs to support that Loan Growth. It can build up this Equity internally via Net Income generation and externally via capital raised from shareholders.
• Return on Equity (ROE) is critical because it represents how efficiently the bank generates after-tax profits based on this “buffer capital” required to back up its lending activities in the case of unexpected losses.

If a bank does not use this “buffer capital” very efficiently, investors will penalize it, and it will tend to trade at lower valuation multiples.

But if it does use this “buffer capital” efficiently, it will be rewarded in the form of higher valuation multiples.

Return on Equity (ROE): Example Calculation and Benchmarking for Large Commercial Banks

To demonstrate the ROE calculation, we’ll examine the top 4 commercial banks in the U.S. – JP Morgan, Citi, Wells Fargo, and Bank of America – with a focus on Citi vs. JPM.

Here are the numbers over a 5-year period for each bank:

JPM’s median ROE over this period is twice as high as Citi’s, so it is no surprise that its P / BV multiple of 2.0x far exceeds the Citi multiple of 0.7x:

Interestingly, JPM’s P / E multiple is lower than Citi’s, but this might be due to issues such as non-recurring charges.

Also, the P / E multiple tends to correlate more strongly with Net Income Growth or Earnings per Share Growth.

If we expand this set and examine the 4 biggest commercial banks in the U.S., R^2 between ROE and P / BV is 0.99!

Of course, ROE is not the only cause, as Loan Growth, the Net Interest Margin (NIM), and regulatory capital differences also factor in, but it is clearly important if R^2 is 0.99.

Interestingly, this correlation is non-existent for ROE vs. the P / E multiples:

In this case, we’d focus on the P / BV multiples to value these banks because the P / E multiples are close to nonsensical.

Given that JPM is far outperforming the other companies in terms of Loan Growth and ROE, its P / BV should be significantly higher as well.

Return on Equity (ROE) for Regulated Utilities Companies

In the power & utilities sector, ROE is also quite important, but for different reasons.

In this sector, regulated utilities companies have a “Rate Base,” which represents the book value of their power plants, transmission lines, distributions, and other infrastructure, with some adjustments.

Essentially, it’s Net PP&E on the Balance Sheet with deductions for unregulated power assets and Deferred Tax Liabilities and additions for Working Capital and a portion of the Construction/Work-in-Progress.

Regulators then set the allowed Debt / Total Capital ratio that can fund these assets and the authorized Return on Equity (ROE).

The company then uses these requirements to “back into” the rates it is allowed to charge for its electricity, gas, and water.

To illustrate, let’s walk through a simple example for MGE Energy, a utility company based in Wisconsin in the U.S.

MGE provides both electricity and gas, but we’ll focus on just the electricity segment here to simplify and save time.

The company’s Average Rate Base for just Electricity in the historical period is $1.16 billion according to the filings:

The regulators allow an Equity / Total Capital ratio of 55.63%, which means that MGE’s “Electric Equity” is $646.7 million.

At an Authorized ROE of 9.8%, this means the company could earn a Net Income of $63.4 million on this Electric Rate Base in the historical period:

According to the 10-K filing, MGE’s effective tax rate is 19.1%, so we can say the Pre-Tax Income is $63.4 / (1 – 19.1%) = $78.3 million.

And then we can add back the company’s expenses, including the Net Interest Expense, Depreciation & Amortization, Operating Expenses, and COGS for this segment, to determine the “Allowed” Revenue:

These expenses all come directly from the company’s filings, where they split up the numbers by segment.

Elsewhere in the filing, the company discloses its total electricity sales of 3,291,110 Kilowatt-Hours (kWh) in thousands… which means this is actually Megawatt-Hours (MWh):

So, we take the estimated Revenue in millions USD, divide by the electricity sales in MWh, and multiply by 1,000 to get the rate in $ / kWh (without the 1,000, this would be in $ / Watt-Hour, which is not a standard metric):

A quick online search reveals that the average electricity rate paid by residents of Wisconsin at this time was in a similar range as the $0.15 / kWh shown here:

If we were building a 3-statement model or valuation for MGE, this Electricity Rate would change in each period based on the Rate Base, Authorized ROE, Operating Expenses, and capital structure.

Final Thoughts on Return on Equity (ROE)

Return on Equity is useful mostly for commercial banks, insurance firm, and regulated utilities because it tells you something about the company’s operational efficiency and valuation (financials) or acts as a key model/operational driver (utilities).

While you can calculate ROE for other types of companies, it’s far less useful because it depends on the company’s capital structure.

So, it has the same pitfalls as a valuation multiple like P / E, which is also affected by the company’s mix of Debt and Equity.

Normally, when you value and benchmark companies in other industries, you want to do so on a capital structure-neutral basis, i.e., by factoring in all the investor groups with metrics like Return on Invested Capital and multiples like TEV / EBITDA.