The return on equity, or ROE, is defined as the amount of profit or net income a company earns per investment dollar. It reveals how much profit a company earns with the money shareholders have invested. The investment dollars differ in that it only accounts for common shareholders. This is often beneficial because it allows companies and investors alike to see what sort of return the voting shareholders are getting, if preferred, and other types of shares that are not counted.
The term can be confusing as it has various aliases. Return on Equity used to be called Return on Common Equity; however, ROCE now refers to Return on Capital Employed. Return on Equity is equivalent to Return on Net Worth (RONW).
ROE is a measure of how well a company uses its investment dollars to generate profits; often times, it is more important to a shareholder than return on investment (ROI). It tells common stock investors how effectively their capital is being reinvested. A company with high return on equity (ROE) is more successful in generating cash internally. Investors are always looking for companies with high and growing returns on common equity. However, not all high ROE companies make good investments. The better benchmark is to compare a company’s return on common equity with its industry average. The higher the ratio, the better the company.
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The return on equity formula is as follows:
ROE = Net Income (NI)/ Average Shareholder’s Equity
The Net Income accounts for the full fiscal year (prior to dividends paid to common stock holders and after dividends paid to preferred stock holders).
The average shareholder’s equity is found by combining the beginning common stock for the year, on the balance sheet, and the ending common stock value. These values are then divided by two for the average amount in the year and do not include preferred shares.