Return on Equity

Overview of Return on Equity

Return on Equity, or ROE, is a measure of a company’s profitability that takes into account shareholders’ equity. It indicates how effectively a company uses the money invested by its shareholders to generate earnings growth. To calculate ROE, we divide the net income (from the fiscal year) by the shareholders’ equity (excluding preferred shares).

Here’s a simple formula we use in financial analysis:

ROE Formula
ROE (%) = (Net Income / Shareholder’s Equity) x 100

We examine ROE to gauge a firm’s financial performance in comparison to other companies in the same industry. It’s an indicator of management’s ability to generate profits from the equity available to them. Generally, a higher ROE suggests that a company is using its funds more effectively.

Moreover, we scrutinize changes in ROE over time to understand the trends in a company’s operational efficiency. But we’re cautious; an extremely high ROE could be due to high levels of debt rather than operational prowess. We also compare ROE across different industries, being mindful that capital-intensive industries often have lower ROEs than technology or consulting firms.

To put it simply, Return on Equity helps us answer a critical question: “Are we getting a good bang for our shareholders’ buck?”