Return on Equity: What is it?

Definition

Return on equity (ROE) is a key financial ratio that measures the profitability of a company in relation to its shareholders’ equity. It provides insight into how effectively a company is utilising the investment made by its shareholders to generate profits.

What is return on equity?

ROE is expressed as a percentage and is widely used by investors, analysts, and managers to assess a company’s financial performance.

Return on equity can be calculated using the following formula:

ROE = (net income / shareholder’s equity) x 100%

A higher ROE indicates that a company is generating more profits relative to the amount of equity invested by shareholders. It suggests that the company is effectively using shareholders’ capital to generate returns. On the other hand, a lower ROE may indicate that the company is less efficient in generating profits from shareholders’ equity. This could be due to various factors, including lower profit margins or inefficient use of resources.

ROE is often used for comparing the performance of companies within the same industry. It provides a relative measure of how well a company is utilising shareholders’ equity compared to its peers.

ROE does not provide insights into the absolute size of profits or the level of risk involved in generating those profits. A company with a high ROE may have lower absolute profits than a larger, lower ROE company.

Example of return on equity

XYZ Corporation reported a net income of £500,000 for the year ending December 31, 2023. Their shareholders’ equity at the beginning of the year was £2,000,000, and at the end of the year, it was £2,500,000.

To calculate ROE we use the formula from above with an average equity of £2,250,000:

ROE = £500,000 / £2,250,000 = 0.2222 or 22.22%

This means that for every pound of shareholders’ equity, XYZ Corporation generated approximately 22.22 pence in net income during the year.