Return on Equity

Return on Equity (ROE) is equal to a fiscal year’s net income (after preferred stock dividends but before common stock dividends) divided by total equity (excluding preferred shares), expressed as a percentage.

Return on Equity = Net Income/Shareholder’s Equity

ROE shows how well a company uses investment funds to generate earnings growth. ROEs between 15% and 20% are generally considered good.

Lets look at an example below:

Let’s assume Company ABC generated $5 million in net income last year. If Company ABC’s shareholders’ equity equaled $20 million last year, then using the ROE formula, we can calculate Company ABC’s ROE as:

ROE = $5,000,000/$20,000,000 = 25%

This means that Company ABC generated $0.25 of profit for every $1 of shareholders’ equity last year, giving the stock an ROE of 25%.

Why it Matters:

ROE is more than a measure of profit; it’s a measure of efficiency. A rising ROE suggests that a company is increasing its ability to generate profit without needing as much capital. It also indicates how well a company’s management is deploying the shareholders’ capital. In other words, the higher the ROE the better. Falling ROE is usually a problem.

However, it is important to note that if the value of the shareholders’ equity goes down, ROE goes up. Thus, write-downs and share buybacks can artificially boost ROE. Likewise, a high level of debt can artificially boost ROE; after all, the more debt a company has, the less shareholders’ equity it has (as a percentage of total assets), and the higher its ROE is.

Some industries tend to have higher returns on equity than others. As a result, comparisons of returns on equity are generally most meaningful among companies within the same industry, and the definition of a “high” or “low” ratio should be made within this context.

 

3 Comments

  1. read more

    I will definitely be reading more if you keep producing posts like this one.

  2. Calgary internet Marketing

    Hi to every one, the contents present at this web page are really awesome for
    people experience, well, keep up the nice work fellows.

  3. Dominique

    Keep this going please, great job!

    Here is my web blog; nokiafunclup.com – Dominique,

Leave a Comment

Your email address will not be published. Required fields are marked *