Return on Equity

Key Question

How profitable is the company for its shareholders?

Return on Equity-2

This ratio indicates how profitable a company is by comparing its net income to its total  equity. The return on equity ratio (ROE) measures how much the shareholders earned for their investment in the company. The higher the ratio percentage, the more efficient management is in utilizing its equity base and the better return is to the shareholders.

Formula:
ROE = Net Income / Shareholder’s Equity

ROE ratio is an important measure of a company’s earnings performance. The ROE informs shareholders regarding how effectively their money is being employed. Peer company, industry and overall market comparisons are appropriate.

In broad terms, financial analysts consider return on equity ratios in the 15-20% range as representing attractive levels of investment quality.

One needs to be aware that a disproportionate amount of debt in a company’s capital structure often translates into a smaller equity base. Thus, a small amount of net income could still produce a high ROE off a modest equity base.

The point here is – do not look at a company’s return on equity in isolation. A high, or low, ROE needs to be interpreted in the context of a company’s debt-equity mix.