Return on Equity
Profit generated per dollar of equity.
Formula
Variables
Example
Measures profitability
How it works
Return on Equity (ROE) shows how much net profit a business earns from the money that shareholders have invested in it. It works by comparing profit after all expenses to the book value of equity, so it measures how efficiently management is using owners’ capital to generate earnings. A higher ROE generally means the company is creating more profit for each dollar of equity, though it should always be judged alongside risk and debt levels.
When to use it
Use ROE when comparing the profitability of companies of similar size or in the same industry, especially from an investor’s perspective. It is also useful when assessing whether management is using shareholder funds effectively over time.
Worked example, step by step
Net Income = $2,400,000 Equity = $12,000,000 ROE = (Net Income / Equity) × 100 ROE = ($2,400,000 / $12,000,000) × 100 ROE = 0.20 × 100 ROE = 20% So, the company generated $0.20 of profit for every $1 of equity, or a 20% return on equity.
Common mistakes to avoid
- Using revenue instead of net income in the numerator
- Confusing shareholder equity with total assets or market value
- Comparing ROE across companies without considering differences in debt or industry
Did You Know?
Return on equity is Warren Buffett's favourite single gauge of how well a company uses shareholder money.
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