Return on equity

Return on equity (ROE) measures the rate of return for ownership interest (shareholders' equity) of common stock owners. It measures the efficiency of a firm at generating profits from each unit of shareholder equity, also known as net assets or assets minus liabilities. ROE shows how well a company uses investments to generate earnings growth. ROEs 15-20% are generally considered good.

The formula

ROE is equal to a fiscal year net income (after preferred stock dividends, before common stock dividends), divided by total equity (excluding preferred shares), as a percentage. As with many financial ratios, ROE is best used to compare in the same industry.

High ROE yields no immediate benefit. Since stock prices are most strongly determined by earnings per share (EPS), a 20% ROE company will cost twice the amount (in Price/Book terms) as a 10% ROE company.

The benefit of low ROEs comes from reinvesting earnings to aid company growth. The benefit can also come as a dividend on common shares or as a combination of dividends and company reinvestment. ROE is less relevant if earnings are not reinvested.