Return on Equity

Return on Equity is a profitability metrics. It is the amount of net income returned as a percentage of shareholders equity. A corporation's profitability is measured by revealing how much profit a company generates with the amount of money shareholders have invested in the company.  

ROE is expressed as a percentage and calculated as:

Return on Equity = Net Income/Shareholder's Equity

A high return on equity in a business is more likely to be one that is capable of generating cash internally.Return on equity (ROE) stands as a crucial for the investors and also would be beneficial if he properly understood its uses. ROE encompasses the three main "levers" by which management sustain the organization-- profitability, asset management, and financial leverage.

Many investors use this as a tool for finding competitively advantageous companies. In the long run companies that generate higher profits with the assets they have in the organization represent a more viable and beneficial in financial terms investment.

Return on equity has many advantages but it also overdrawn by a few disadvantages. The investors should be aware of its cons. The ROE can be artificially inflated by dividing it with a smaller book value. A smaller book value may be caused by borrowing of funds rather than issuing stocks. The book value can also be reduced by stock buy backs etc. this may result in the increase of ROE but the profits do not improve. The investor should analyze the ROE of a company over a long period of time and not just that of the previous year. This would bring out a more realistic view and eliminate the abnormalities, if any.

Questions:

• What is Return on Equity?
• What is an ideal ROE for a company?
• How can an investor carefully analyze the ROE of a company?