The percentage a company earns on its total equity for the time period listed. The calculation is net income divided by end-of-year net worth. The resulting figure is multiplied by 100.
Benefit
Return on equity shows how much profit a company generates on the money shareholders have invested in the company. The mission of any company is to earn a high return on equity.
Origin
The company’s net income is found in the annual income statement. The company’s net worth is taken from the company’s annual balance sheet.
For the Pros
Return on equity can be broken down as the product of three ratios:
ROE = Net margin * Asset turnover * Financial leverage
Thus a company can produce a high ROE either by adding a lot of value to its products (thus leading to a high profit margin), selling a lot of goods (leading to a high asset turnover), or by loading up on debt (jacking up financial leverage, which is defined as assets divided by shareholders’ equity). To see how any particular company generates its ROE, look at the breakdown. If a company is relying on a high financial-leverage ratio, it signals that the company is pursuing a high-risk, high-return strategy.
Use the following formula to find companies that have dramatically improved their ROEs. The same equation can be used on ROA:
((ROE Year 1 – ROE Year 5) / ROE Year 5) x 100