Harbor Coffee, our fictional coffee business, earned about $28.33 for every $100 of average owners' book equity in its third fiscal year, FY3. You're deciding whether that number is evidence of a good business.
Suppose only its average equity balance shrank. The same profit could produce $35.42 per $100 instead. Would you rate Harbor more highly?
The ratio rose without another dollar of profit. A better-looking number needs an explanation.
What the owners' capital earned
Return on equity (ROE) compares a year's net profit with owners' book equity — assets minus liabilities. It measures profit against the owners' accounting stake in the business.
For common shareholders, use profit available to them, after preferred dividends, divided by average common equity. Both halves must belong to the same owners.
Book equity is the balance sheet's value for that stake, not the stock market's price for it. A 28.33% ROE does not mean your shares earn 28.33%. Your investment return comes from share-price changes and dividends, measured against what you paid.
Calculate Harbor's ROE
Harbor has no preferred shares or minority interests, so all its net income and equity belong to common shareholders. Its FY3 statement figures are below, in millions of dollars.
| Input | FY3 ($m) | Status |
|---|---|---|
| Annual net income | 150 | Reported |
| Opening equity | 514.4 | Reported |
| Closing equity | 544.4 | Reported |
| Average equity | 529.4 | Calculated |
Average common equity is the common owners' book stake averaged over the year. A simple estimate adds the opening and closing balances and divides by two: ($514.4 million + $544.4 million) ÷ 2 = $529.4 million.
$150 million ÷ $529.4 million × 100% = 28.33%. Harbor earned $28.33 in FY3 for every $100 of average book equity.
Profit covers a year; closing equity captures one day. Averaging gives a better match. If equity changes sharply during the year, quarterly or monthly balances can make the average more representative.
Compare it with the right yardstick
Using the same method, Harbor's ROE eases from 28.94% in FY1 to 28.57% in FY2 and 28.33% in FY3, even as annual profit rises from $135 million to $142.5 million to $150 million.
The earlier equity balances are $450 million at the start of FY1, $483 million at its close, and $514.4 million at the close of FY2.
Harbor earns more dollars, but less per dollar of equity. Its average equity base has grown faster than earnings.
Compare Harbor with its own history, then with similar businesses. It gets 70% of sales from packaged coffee and 30% from shops. Another coffee producer with shops is a better yardstick than a bank or a software company.
Asset needs, accounting choices and debt levels all affect ROE. There is no single percentage where every business becomes "good." A ranking without a reason for the gap tells you little.
A smaller denominator can flatter
Keep Harbor's FY3 profit at $150 million and make average equity 20% smaller: $529.4 million × 0.80 = $423.52 million.
ROE becomes $150 million ÷ $423.52 million × 100% = 35.42%. That is a 25% relative increase because 1 ÷ 0.80 = 1.25. The longer bar comes entirely from less equity beneath the same profit.
A share buyback spends cash to repurchase shares, reducing book equity. A real buyback may also lower income earned on cash or add interest expense if funded with debt.
Borrowing amplifies gains and losses for equity owners. Whether it helps depends on what the borrowed money earns versus what it costs.
Harbor's 28.33%, close to its prior two years, supports a case for consistent profitability. The 35.42% case adds no evidence of better operations. A smaller denominator hasn't sold another bag of coffee.
When to set the number aside
An abrupt jump deserves a look at both profit and equity. A gain from selling an asset can lift one year's profit without improving the ongoing business.
A write-down reduces an asset's recorded value and equity. The charge can hurt profit in that year, then flatter later ROE by leaving a smaller denominator. A past loss can make a later ratio look better.
DuPont analysis will later separate the effects of margins, asset use and financing. Price-to-book connects profitability with a different question: the price investors pay for the equity.
First, ROA and ROIC widen the view beyond owners' equity to the assets and operating capital behind Harbor's profit.
In short
- ROE measures annual accounting profit against owners' book equity.
- A 28.33% ROE means $28.33 of annual profit per $100 of average common equity, not a 28.33% return on your shares.
- Compare the same business through time and similar businesses with each other.
- A higher ROE caused by shrinking equity is not proof of better operations.