Return on average equity is a financial metric measuring a company’s profitability in relation to average shareholders’ equity. It is expressed as a percentage, equal to net income after tax divided by the average shareholder equity for a given period. Return on average equity measures how well a company uses investments to generate additional profits and can be a useful method for comparing firms across the same industry.
Return on average equity is a modification of return on equity. Return on equity equals net income after tax divided by invested capital, measured by stockholders’ equity. Net income is calculated before dividends are paid out to common stock holders but after preferred stock dividends are paid. The difference between the two metrics occurs in the denominator. Return on equity is based on the current value of shareholders’ equity while return on average equity uses an average shareholder equity value.
Return on average equity often provides a better understanding of company profitability than standard return on equity calculations. This is especially true when average stockholders’ equity changes significantly during the fiscal year. Average stockholder equity is calculated by adding the initial stockholder’s equity value to the end of the period value and dividing by two.
If average stockholders’ equity has not varied in the measured period, both return on equity and return on average equity will be the same. Variation can be predicted by calculating return on equity at the beginning and at the end of the measurement period. The change in these two numbers provides a picture of the change in profitability.
A positive return on average stockholders’ equity can mean that the company has been successful in utilizing assets to produce a profit, but this is not always the case. This metric can be misleading, as net income can be influenced by debt and high asset turnover. For example, a high proportion of debt in the capital structure can increase the return on equity, but will neglect to show debt risks and costs of repayment.
A high return on average equity can also symbolize the potential for company growth, but does not guarantee it. This means that firms may have funds to grow or to pay dividends, but a high return on equity does not guarantee that the firm will reinvest these funds. Metrics must, therefore, be assessed with other company strategies and history for better organizational understanding.