Return on Equity

    By
    Andrey Orlov
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    Return on equity (ROE) is the rate of return that a company generates with the money shareholders have invested.

    It is calculated with the following formula:

     

    If the net income of the company is $10,000 and shareholders have invested $100,000, the ROE would be 10%. Net income is for the whole fiscal year. It does not include dividends paid to common stock holders (which is calculated with a different formula), but it does include the dividends paid to preferred stock. Shareholder’s equity does not include preferred shares.

    For common stocks, the Return on Common Equity (ROCE) formula is:

     

    The return on equity shows how efficient the company is with the money that shareholders have invested. The ROE of a company should be used in conjunction with other companies from the same industry in order to see how profitable the company is compared to the competition.

    Note that a high ROE offers no immediate benefit to investors. Share prices are chiefly affected by earnings per share (EPS), meaning you would pay twice as much (based on the price/book ratio) for a 20% ROE company as you would for a 10% ROE company.

    However, when the earnings are reinvested in the company at a high ROE rate, this delivers a high growth rate. Investor benefits can also come in the shape of a dividend on common shares or as a combination of dividends and reinvestment in the company.