Unlike the more commonly known term Return on Investment, Return on Equity (ROE) defines the amount of net income that is returned as a percentage of a shareholder’s equity. You might also see the term Return on Net Worth (RONW) used interchangeably. This tool is used to measure the profitability of a company by displaying just how much profit the company generates from the funds that shareholders have invested.
ROE is defined as a percentage which is calculated by the formula:
Return on Equity = Net Income/Shareholder’s Equity
The full year’s net income is used, before common stock holders are paid their dividends, but after the dividends of preferred stock are paid out.
Using ROE is useful if you want to compare the profitability of more than one company in the same line of work. Additionally, by looking at changes in ROE over time an investor my get a better idea of how the company’s profitability changes in certain market conditions. Furthermore, just because a company has a high ROE yield doesn’t mean it is of benefit to the investor. In fact, chances are they will end up paying more for the stock without a commensurate gain down the line.
Where a good return on equity does help is that the earnings are reinvested in companies which have high ROE rates. That results in better growth for the company which may provide better dividends for the investor. If the earnings are not being reinvested, knowing the ROE may be irrelevant. Finally, consider that return on equity (ROE) numbers are just as easily manipulated by the company as any other such figures and other tools should be used in conjunction with ROE to determine a wise investment.
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