Return on Equity

Return on equity or ROE is the net income of a company divided by the shareholders total equity. The shareholders total equity is the amount of cash people have invested in the company buying stock. If a company has a net income of $250 million and has total shareholder equity of $1 billion, then the return on equity would be:

ROE = $250 million / $1 billion = 25 percent

This stock measure lets you see the net income or profits that a company makes in a new light. It does this by comparing profit to the amount of money that has been put in the company. In other words, for each dollar invested in the company, how much net income was produced? Presumably a strong company would produce more profit per dollar invested than a weak or poorly managed company. So, generally speaking, a higher ROE indicates a better investment.

Note that net income is income before dividends have been paid to common shareholders, but after dividends have been paid on preferred stock.

ROE is a measure of a companies efficiency.

If two different companies had net incomes of $250 million, but one had $1 billion of shareholder equity (ROE = 25%) and the other company had $2 billion of shareholder equity (ROE = 12.5%), that would tell you that the company with the lower ROE was far less efficient. This is because for every dollar invested in the first company to generate profit, $2 had to be invested in the second company to generate the same level of profit.

Of course you should compare apples to apples. When looking at ROE and comparing companies, make sure they are from the same industry. It wouldn't make sense to compare Google to Toyota Motor Company, for example, because their expenses are going to be totally different.

ROE is one of many important measures of the financial health and investment potential of a company. Generally speaking, look to companies with an ROE of 15 percent or higher, and compare to similar companies in the same industry.

See what Morningstar says about Return on Equity

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