It indicates how efficient a firm is in generating profits from every dollar of net assets.
The ROE is computed as net income available to ordinary shareholders (after preference dividends have been paid) divided by the average total book value of equity.
= Net Income / Average Book Value of Equity
= Net Income /[ (Book Value of Equity FY1 + Book Value of Equity FY2)/2]
An increase in ROE might not always be a positive sign for the company.
- The increase in ROE may be the result of net income decreasing at a slower rate than shareholders' equity. A declining net income is a source of concern for investors.
- The increase in ROE may be the result of debt issuance proceeds being used to repurchase shares. This would increase the company's financial leverage (risk).