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.