Return on equity (ROE) is a measure of a company’s financial performance that shows the relationship between a company’s profit and the investor’s return. ROE illustrates how much profit a company generates with the price shareholders have invested and how successful the firm’s management team is at turning the cash put into the business into greater gains and growth for the company and investors. The higher the ROE, the more efficient the company’s operations are at making use of those funds.
ROE affects how quickly a firm can grow internally by reinvesting earnings. When a company makes money, it can reinvest the funds in the firm or pay out the earnings as dividends to investors, or some combination of the two. In addition, ROE is useful for comparing a company’s profitability with that of its competitors. Companies cannot increase their earnings faster than they can boost their ROE without raising additional cash by taking on new debt or selling more shares.
ROE is typically expressed as a percentage (although it is sometimes referred to as a ratio). The most commonly used formula to calculate ROE is to divide annual net income by shareholder’s average equity for the same period. Net income appears on the company’s income statements, and shareholders’ equity, which shows the difference between total assets and total liabilities, appears on the company’s balance sheet.
ROE = net income / shareholders’ equity
ROE may also be calculated by dividing net income by the average shareholder equity. Average shareholder equity is calculated by adding the shareholders’ equity at the beginning of a period to the shareholders’ equity at period’s end and dividing the result by two
The end-of-period shareholders’ equity can be used as the denominator to determine the ending ROE. Calculating beginning and ending ROE helps investors see the change in profitability over the period.