Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail
Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail

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.

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