Expert: Gina Boykin - 7/30/2008

Question
Hi Gina,
I have a very basic query regarding ROE.  Why is ROE = ROA * Assets/Shareholders Equity and not   ROA * Shareholders Equity/Assets?  My reasoning is as follows: ROA gives us the return on each dollar the company invests in assets.  So much so good.  Now, isn't ROE simply the percentage of this return that shareholders have a claim to?  That's why I would have thought that the formula should be ROA * Assets/Shareholders Equity (where the second argument tells us what percentage of total assets are financed by equity).  If you could enlighten me as to where the logic of my thinking is mistaken, I would be very appreciative,  
Many thanks,
Jeremy

Answer
Actually ROE, return on equity, just equals net income / shareholder's equity, which shows you what a company has made (the return) from the investment of the shareholders. It does not tell you what the owners are entitled to, however. If a company makes $10,000 and the company's equity is $100,000, then the ROE is 10 percent ($10K/$100K).  The company may use all of its net income to invest back in the business, or could give all of it away to its shareholders (in dividends).  Obviously, most companies do something somewhere in betweeen these extremes, but you see why it does not mean that a shareholder is entitled to any particular percent.

ROA, return on assets, is net income / total assets, which shows you how well a company uses its assets to generate a return.