What It Measures
Profitability, specifically the percentage return that was delivered to a company’s owners.
Why It Is Important
ROE is a fundamental indication of a company’s ability to increase its earnings per share and thus the quality of its stock, because it reveals how well a company is using its money to generate additional earnings.
It is a relatively straightforward benchmark, easy to calculate, and is applicable to a majority of industries. ROE allows investors to compare a company’s use of their equity with other investments, and to compare the performance of companies in the same industry. ROE can also help to evaluate trends in a business.
Businesses that generate high returns on equity are businesses that pay off their stockholders handsomely and create substantial assets for each dollar invested.
How It Works in Practice
To calculate ROE, divide the net income shown on the income statement (usually of the past year) by stockholders’ equity, which appears on the balance sheet:
Return on equity = Net income ÷ Owners’ equity
For example, if net income is $450 and equity is $2,500, then:
450 ÷ 2,500 = 0.18 = 18%
Tricks of the Trade
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Because new variations of the ROE ratio do appear, it is important to know how the figure is calculated.
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Return on equity for most companies certainly should be in the double digits; investors often look for 15% or higher, while a return of 20% or more is considered excellent.
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Seasoned investors also review five-year average ROE, to gauge consistency.
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A word of caution: Financial statements usually report assets at book value, which is the purchase price minus depreciation; they do not show replacement costs. A business with older assets should show higher rates of ROE than a business with newer assets.
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Examining ROE with return on assets can indicate if a company is debt-heavy. If a company has very little debt, it is reasonable to assume that its management is earning high profits and/or using assets effectively.
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A high ROE also could be due to leverage (a method of corporate funding in which a higher proportion of funds is raised through borrowing than issuing stock). If liabilities are high the balance sheet will reveal it, hence the need to review it.
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