Return on equity (ROE) is one of the most popular profitability measures used by financial analysts. ROE not only allows you to compare the performance of vastly different companies, but also helps contrast investing in that business with keeping the same money in other instruments, such as bank deposits or bonds. Since ROE is calculated based on balance sheet and income statement figures, all actions that change the relevant numbers will influence ROE.
ROE equals the company's net after-tax profits, divided by average shareholder equity. If the analyst desires, multiplying the figure by 100 will convert the result into a percentage. For example, if a business earned $100,000 after taxes, and total shareholder equity equals $1 million, ROE equals $100,000/$1,000,000 = 0.1. Expressed as a percentage, the shareholders have earned 0.1*100 = 10% on their invested capital. Investors can compare this figure to the ROE of other companies they can invest in or what they can expect to earn by placing the same funds in a mutual fund or bank deposit.
Dividend payments will impact the net shareholder equity on the balance sheet and will therefore influence the ROE figure. When a business pays dividends, its retained earnings will decline. Since retained earnings is added to the paid-in capital to calculate the total shareholder equity, dividend payments will reduce the total shareholder equity on the balance sheet. A reduction in shareholder equity translates to a smaller denominator in the ROE equation. In other words, the analyst divides the net income figure by a smaller number, which results in a larger ROE. In sum, dividends reduce shareholder equity and boost ROE.
Average Shareholder Equity
If the shareholder equity in a company has fluctuated over the period during which the net income has been earned, you need to use the average shareholder equity to calculate ROE. If, for example, the profit used in the formula is for an entire calendar year and shareholder equity has increased from $1,000,000 to $1,100,000 from the beginning of the year until December 31, the average of these figures, or $1,050,000, is the number that should go into the denominator in the ROE calculation. Shareholder equity can fluctuate due to various reasons, including the sale of additional shares to investors, dividend payments or losses.
Although dividend payments boost ROE by reducing the denominator in the formula over the short term, the long-term effects are harder to predict. Paying dividends means giving some of the cash in the company's bank accounts to shareholders. If this cash was far in excess of the company's needs and was sitting idle, its distribution will likely have no effect on profits. If, however, paying this sum means forgoing profitable investment options, long-term profits will likely take a hit. In such cases, the net effect on ROE depends on whether the decline in earnings or the reduction in shareholder equity as a result of dividend payments is greater.
Hunkar Ozyasar is the former high-yield bond strategist for Deutsche Bank. He has been quoted in publications including "Financial Times" and the "Wall Street Journal." His book, "When Time Management Fails," is published in 12 countries while Ozyasar’s finance articles are featured on Nikkei, Japan’s premier financial news service. He holds a Master of Business Administration from Kellogg Graduate School.