Return on Shareholders' Equity

Return on Shareholders' Equity

This 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 stocks, 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 shareholders 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 shareholders' equity, which appears on the balance sheet:

ROE
= net income/owner's equity

TRICKS OF THE TRADE

• Because new variations of the ROE ratio do appear, it is important to know how the figure is calculated.
  
• ROE for most companies certainly should be in double figures; investors often look for 15% or higher, while a return of 20% or more is considered excellent.
  
• Seasoned investors also review 5-year average ROE, to gauge consistency.
  
• 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.
  
• Examining ROE with ROA (return on assets) can indicate if a company is debt-heavy. If a company owes very little debt, then it is reasonable to assume that its management is earning high profits and/or using assets effectively.
  
• A high ROE also could be due to leverage (a method of corporate fudning in which a higher proportion of funds is raised through borrowing than share issue). If liabilities are high the balance sheet will reveal it, hence the need to review it.