What Is Return on Equity (ROE)?
Return on investment measures how well you generate profits from company assets. Return on equity (ROE) measures the profit earned for each dollar invested in a company’s stock. You figure it by dividing net income by average owners’ equity, which is what’s left over in the business after all liabilities are subtracted from all assets.
The higher the ROE ratio, the more efficient management is at utilizing its equity base. This measurement is important to stockholders and potential investors because it compares earnings to owners’ investments (equity).
Because this calculation takes into account retained earnings — the company’s cumulative net income less dividends — it gives the investors much-needed data as to how effectively their capital is being used. Having net income grow in relation to increases in equity presents a picture of a well-run business.
Take a walk through a quick calculation. If a company’s net income is $35,000 and the average owners’ equity is $250,000, ROE is 14 percent ($35,000 / $250,000). Once again, to make wise investment decisions, users of this information look at ROE as it trends over a series of years and compare it to the ROE of other companies.