Return on Equity (ROE)
The profit generated for each dollar of shareholders’ equity.
Formula
Variables
Example
$70k / $200k = 35% ROE
How it works
Return on equity measures how effectively a company turns the owners’ invested capital into profit. It works by comparing net income, which is the profit left after all expenses and taxes, to shareholder equity, which represents the book value of the owners’ claim on the business. A higher ROE generally means the company is generating more earnings from each dollar supplied by shareholders, though leverage and accounting choices can affect the result.
When to use it
Use ROE when comparing profitability across companies or tracking how efficiently management is using shareholders’ funds over time. It is especially useful for investors, analysts, and business owners evaluating performance in relation to the capital invested by owners.
Worked example, step by step
Net Income = $48,000 Shareholder Equity = $300,000 ROE = Net Income / Shareholder Equity ROE = $48,000 / $300,000 ROE = 0.16 ROE = 16% So, the company generated 16 cents of profit for each $1 of shareholder equity.
Common mistakes to avoid
- Using revenue instead of net income in the numerator
- Dividing by total assets instead of shareholder equity
- Forgetting to convert the decimal result into a percentage when reporting ROE
Did You Know?
Warren Buffett famously prizes a durable, high ROE as a hallmark of a great business.
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More in Accounting
View allAccounting Equation
BasicThe foundation of double-entry bookkeeping: everything a business owns is financed either by debt or by owners’ capital.
Cost of Goods Sold
BasicThe direct cost of the inventory actually sold during a period.
Gross Profit
BasicWhat remains from sales after subtracting the direct cost of the goods sold, before operating expenses.
Net Income
BasicThe “bottom line” — total earnings after all expenses, interest and taxes are deducted from revenue.
Retained Earnings
BasicCumulative profit kept in the business rather than paid out to shareholders.
Current Ratio
IntermediateA liquidity measure of whether a firm can cover its short-term obligations with short-term assets.