Return on Equity (ROE)
What it is:
Return on equity (ROE) is a measure of profitability that calculates how many dollars of profit a company generates with each dollar of shareholders' equity. The formula for ROE is:
ROE = Net Income/Shareholders' Equity
ROE is sometimes called "return on net worth."
How it works/Example:
Let's assume Company XYZ generated $10 million in net income last year. If Company XYZ's shareholders' equity equaled $20 million last year, then using the ROE formula, we can calculate Company XYZ's ROE as:
ROE = $10,000,000/$20,000,000 = 50%
This means that Company XYZ generated $0.50 of profit for every $1 of shareholders' equity last year, giving the stock an ROE of 50%.
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.