Return on equity (ROE) is an important metric of profitability. It compares a company’s net profit directly to the value of the company’s equities – what the shareholders outright own. Equity has many meanings – in this context it refers to what a shareholder owns in a corporation.
ROE is also known as return on net worth or return on owners’ investment.
While being called the ‘mother of all ratios’, return on equity has also been accused of being partly responsible for the downfall of several banks during the 2008 global financial crisis (they went on a debt-fueled spending boom).
Investors say that ROE tells you how much bang you get for the buck you’ve invested as a shareholder.
ROE is calculated by dividing a company’s net income for the fiscal year (after preferred stock dividends but before common stock dividends) by total equity (excluding preferred shares). The result is represented as a percentage.
ROE and return on common equity reveal how earnings compare to the shareholders investment. This is different from return on assets (ROA), which compares earnings to the owners’ investments and any asset investments made from borrowed capital.
What information does ROE provide an investor?
A high ROE does not mean there will be any immediate benefit. However, it can indicate that earnings will be reinvested in the company – helping the company grow faster. ROE can potentially mean nothing if the earnings are not reinvested.
Example of calculating ROE:
Assume a furniture company generated net income of $1,000,000 in fiscal 2013. The shareholders’ equity at the end of fiscal 2012 was $12,00,000 and at the end of fiscal 2013 it was $14,000,000.
Average Shareholders’ Equity = ($12,000,000 + $14,000,000) / 2 = $13 million
Return On Equity = $1,000,000 / $13,000,000 ≈ 0.077 or 7.7%
Video – Return on Equity Explained