by The return on equity ratio or ROE is a profitability ratio that measures the ability of a firm to generate profits from its shareholders investments in the company. In other words, the return on equity ratio shows how much profit each dollar of common stockholders’ equity generates.
So, a return on 1 means that every dollar of common stockholders’ equity generates 1 dollar of net income. This is an important measurement for potential investors because they want to see how efficiently a company will use their money to generate net income.
ROE is also an indicator of how effective management is at using equity financing to fund operations and grow the company.
Formula
The return on equity ratio formula is calculated by dividing net income by shareholder’s equity.
Return on Equity Ratio = Net income / Shareholder’s Equity
Most of the time, ROE is computed for common shareholders. In this case, preferred dividends are not included in the calculation because these profits are not available to common stockholders. Preferred dividends are then taken out of net income for the calculation.
Also, average common stockholder’s equity is usually used, so an average of beginning and ending equity is calculated.
Analysis
Return on equity measures how efficiently a firm can use the money from shareholders to generate profits and grow the company. Unlike other return on investment ratios, ROE is a profitability ratio from the investor’s point of view not the company. In other words, this ratio calculates how much money is made based on the investors’ investment in the company, not the company’s investment in assets or something else.
That being said, investors want to see a high return on equity ratio because this indicates that the company is using its investors’ funds effectively. Higher ratios are almost always better than lower ratios, but have to be compared to other companies’ ratios in the industry. Since every industry has different levels of investors and income, ROE can’t be used to compare companies outside of their industries very effectively.
Interpreting the Return on Equity
The return on equity is similar to the “return on assets”. Assets come from two sources: debt and equity. The ROE focuses on the latter. Return on equity measures profitability using resources provided by investors and company earnings.
A high return on assets shows than the business was able to successfully utilize the resources provided by its equity investors and the company’s accumulated profits in generating income. Nonetheless, just like any other financial ratio, the ROE is more useful if it is compared to a benchmark such as the average ROE in the industry where the company operates or the company’s ROE in the past years.
