ROE Question

I noticed that ROE is not calculated consistently. Most of the time it is calculated as Net Income (from current year income statement) / Equity (in current year balance sheet). However it seems that at other times, it is calculated as Net Income (from current year income statement) / Equity (in previous year balance sheet) especially for residual income calculation.

How to be sure which equity to use so you do not needlessly throw away questions?

Well for residual income your dividing NI/Bt-1 because the formula is NI- Bt-1 * r. I think. It’s just that equation cause it makes it easier to write.

Usually it’s NI/Bcurrent

However if you think of ROE as return on equity. It should be the net income generated for the year based on beginning of year equity. By conveniently using current year net income in numerator and current end of year equity as denominator does not accurately represents the notion of return based on provided equity because you are including a current period NI in the numerator and also including current period retained earnings under denominator that does not exist at the beginning of the year.

Not sure if I’m making it more complicated to understand. But it seems that ROE has different ways of calculation based on the context. If it is residual income context, then use beginning equity. Otherwise it is safe to use end of period equity shown in current year balance sheet.