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Word of the Week 'Return on Equity'

What is 'Return on Equity (ROE)'

Return on equity (ROE) is the amount of net income returned as a percentage of shareholders' equity. Return on equity (also known as "return on net worth" [RONW]) measures a corporation's profitability by revealing how much profit a company generates with the money shareholders have invested.

ROE is expressed as a percentage and calculated as:

Return on Equity = Net Income/Shareholder's Equity

Net income is for the full fiscal year (before dividends paid to common stockholders but after dividends to preferred stock.) Shareholders' equity does not include preferred shares.

BREAKING DOWN 'Return on Equity (ROE)'

ROE is useful in comparing the profitability of a company to that of other firms in the same industry. It illustrates how effective the company is at turning the cash put into the business into greater gains and growth for the company and investors. The higher the return on equity, the more efficient the company's operations are making use of those funds.

How Return on Equity Is Determined

There are several variations on the formula that investors may use:

  1. Investors wishing to see the return on common equity may modify the formula above by subtracting preferred dividends from net income and subtracting preferred equity from shareholders' equity, giving the following: return on common equity (ROCE) = net income - preferred dividends / common equity.

  2. Return on equity may also be calculated by dividing net income by the average shareholder equity. Average shareholder equity is calculated by adding the shareholders' equity at the beginning of a period to the shareholders' equity at period's end and dividing the result by two.

  3. Investors may also calculate the change in ROE during a specific period by first using the shareholders' equity figure from the beginning of the period as a denominator to determine the beginning ROE. Then, the end-of-period shareholders' equity can be used as the denominator to determine the ending ROE. Calculating both beginning and ending ROEs allows an investor to determine the change in profitability over the period.

Things to Remember

  • If new shares are issued, you use the weighted average of the number of shares throughout the year.

  • For high growth companies, you should expect a higher ROE.

  • Averaging ROE over the past five to 10 years can give you a better idea of the company's historical growth.

For more on return on equity (ROE) read "Are Companies With a Negative Return on Equity (ROE) Always a Bad Investment?" and "ROA and ROE Give Clear Picture of Corporate Health."