Return on Equity
What is Return on Equity (ROE)?
The term Return on Equity, or ROE, measures the amount of profit that a company generates through the use of shareholders' equity. ROE is one of the most important profitability ratio's measuring management's ability to perform in areas of profitability, asset management, and financial leverage. It is calculated by dividing net income by average common shareholders equity. The reason we use an average here is due to the fact that common outstanding shares can fluctuate in size throughout the year. Companies may bring additional shares to the market or actually buy them back depending on their cash needs and expectations for the future.
It is generally accepted that a company with a higher ROE is a better investment than one with a lower ROE since it has a stronger ability to generate cash flows internally; however, this is not completely accurate. Some firms which have lower asset requirements may have sky high ROE but the risk of them continuing to maintain that ROE is not very high as the market for their offering will invite many competitors. Conversely, there are many industries that rely heavily on large capex spending to get their business off the ground; transportation and oil companies come to mind. These firms will have less competition due to the high start up costs. The moral of the story here is to understand the industry that you are investing in and compare apples to apples.
Return on Equity Calculation
In its simplest form, the formula used to calculate ROE is very simple; however, let's take a look at the three components of ROE as we discussed above. Keeping track of ROE by measuring each of these three components individually allows companies to easily identify changes which are affecting their ROE.
When we simplify this formula, we arrive at:
Net income can be found on the income statement while average common shareholders equity can be found on the balance sheet by averaging the current fiscal years shareholders equity with the prior years.