Understanding Return on Equity

Return on Equity is a profitability ratio used by analysts and investors to gauge the performance of management and the future value of a company. By comparing net income to average shareholders' equity, ROE tells common shareholders how effectively a company is spending its money. Comparing ROE to an industry as a whole, as well as an overall market, helps determine the attractiveness of an investment.

Difficulty: Moderate

Instructions

Things You'll Need:

• Balance sheet
• Income statement
• Calculator

1. 
    

   Determine net Income. The numerator in the return on equity ratio is net income, which may be found on the income statement of a company's quarterly report.

2. 
    

   Determine shareholder equity. The denominator in the ROE ratio is shareholder equity, which is listed on the balance sheet of a company's quarterly report. In most cases, analysts will use a series of equity values representing a given period of time and find the average. Using the average value gives a more reliable ROE calculation.

3. Do the math. Dividing net income by average shareholder equity yields return on equity, or how well the company converted investment into profit over a given period. Generally, 15% to 20% is considered attractive, but significant variations exist across different industries and business models.

4. Determine the application. Generally, 15% to 20% is considered attractive return on equity, but significant variations exist across different industries and business models. The best application is between companies with similar business models, though comparisons across industries can describe the relative profitability of two different sectors in the economy.

Tips & Warnings

• If a company has outstanding preferred stock, it's necessary to subtract the preferred dividends from net income and the outstanding amount of preferred equity to find the return on equity for common shareholders.
• ROE is subject to distortions if a company has a disproportionate amount of debt. This would shrink the equity base (the denominator) and artificially inflate the ratio.

Resources

• ROE
• Understanding ROE