Return on Equity

Return on equity (ROE) refers to the amount of net income returned as a percentage of shareholders equity. Return on equity is a measure of the corporation's profitability by revealing how much profit a company generates with the money shareholders have invested.  It is one of the key measures of profitability for a company and a way to compare different companies when it comes to questions of profitability. ROE is expressed as a percentage and is computed as

Return on Equity = Net Income/Shareholder's Equity

Return on equity measurement can also be calculated in another way i.e. to take the net income and subtract that by the common equity, after divided by the preferred dividends. This is referred to as the return on common equity.  Usually the common dividends are still included in the return on equity. The DuPont formula is another way to calculate the ROE. Under this the sales are divided by net income, which is multiplied by total divided by sales, which is multiplied average stockholder equity divided by total assets. This formula is most complex and it takes more into account.

The investors also calculate the change in ROE for a period by first using the shareholders' equity figure from the beginning of a period as a denominator to determine the beginning ROE. Next the end-of-period shareholders' equity can be used as the denominator to determine the ending ROE. Finally calculating both beginning and ending ROE allows an investor to determine the change in profitability over the period.

In the calculation of ROE the investors should consider a number of different aspects. The ROE helps in determining the overall profitability of the company however there are other factors. For example, those companies with a high overhead may have a lower return on equity, but can still be very profitable and vice versa. Therefore all tools should be taken into account when the decision comes to buying stock

Questions:

• What is return on equity?
• What are the ways in which ROE can be calculated?