Return on equity (ROE) is one of share investing fundamentals and reveals how much profit a company earned (the return) in comparison to the total amount of shareholder equity found on the balance sheet. Shareholder equity is equal to total assets minus total liabilities. It’s what the shareholders “own”. Shareholder equity is a creation of accounting that represents the assets created by the retained earnings (profit) of the business and the paid-in capital of the owners.
ROE is the amount of net income (company earnings or profit) achieved as a percentage of shareholders equity.
ROE measures a corporation’s profitability by revealing how much profit a company generates with the money shareholders have invested (equity).
ROE is expressed as a percentage and calculated as:
ROE = (Net Income (Profit)/Shareholder’s Equity) x 100
For example you owned a business that had a net worth (shareholder’s equity) of $100 million dollars and it made $5 million in profit, it would be earning (return) 5% on your equity ($5 ÷ $100 = .05, or 5%). The aim is to get a higher “return” on your equity. Note net income/profit is for the full fiscal year (before dividends paid to common stock holders but after dividends to preferred stock.) Shareholder’s equity does not include preferred shares.
Another name is “return on net worth” (RONW).
ROE is useful for comparing the profitability of a company to that of other firms in the same industry. A business that has a high return on equity is more likely to be one that is capable of generating cash internally. For the most part, the higher a company’s return on equity compared to its industry, the better.
Why is it important?
ROE is an important measure for a company because it can be used to compare the company profitability against its peer companies. ROE measures performance and generally the higher the better. Some industries have a high ROE as they require little or no assets while others require large infrastructure before they generate profit. For this reason ROE is best used to compare companies in the same industry. Performance ratios like ROE, concentrate on past performance to get a gauge on future expectation.
A business that has a high return on equity is more likely to be one that is capable of generating cash and has less need to borrow. The higher a company’s ROE compared to its industry, the better and the easier it is for the company to raise money for growth. If required – some debt, managed well, can help a business grow.
Further good examples and comparisons of ROE of actual companies in USA can be found at http://www.buffettsecrets.com/return-on-equity.htm.
Caution – Why one ratio and one year is not enough?
ROE from one year does not tell you enough. And as Conscious Investor and Stock Doctor can show the ROE over the years can vary. A consistent and steady ROE (and other ratios) is what is required.
A good point is made at http://www.fool.com/investing/beginning/return-on-equity-an-introduction.aspx in the comments.
On March 23, 2010, at 3:51 AM, fdgxdfgxcf wrote:
“Roe is not as helpful as you think. It is easy to raise ROE with little effects on the valuation of s stock. Consider Netflix, a company who has a current ROE of 36. The extremely high PE was achieved by increasing long term debt by 200 million dollars and using the money borrowed to buy back 100 million dollars worth of stocks. By buying back stocks, the company reduces shareholder’s equity (the denominator), which ultimately increases the ROE. The current ratio will increase because of the extra 100 million dollars from the notes payable. The company seems stronger in the short term and more profitable when judged solely on return on equity. The bad news is that the company incurs a higher long term debt with more interest expense. To be fair to netflix, the stock was bought around 40$ and is now close to $70. Management is praised as an efficient company, but a great extent of it is not due to actual net income but because of strategic accounting techniques.”