Definition

Return on Equity is a financial performance metric that takes a company's Net Income and divides it by Shareholder's equity. This metric is used to gauge a company's profitability and efficiency in earning profits.

Example

ROE = Net Income / Shareholder EquityROE is expressed as a percentage or ratio. Suppose a company's net income is $1.2 million, its preferred dividends are $200,000 and shareholder's equity is $10 million. The first step in ROE calculation is to subtract preferred dividends from the net income:$1.2 million – $200,000 = $1 millionFurther: $1 million / $10 million = 10%ROE of 10% means that for $1 of shareholder equity, the company makes $10 of net income. In effect, this means, that the company's shareholders will earn a 10% return on investment.

Why it matters

Investors look at ROE before investing in a company. It is also used to compare companies. A higher ROE means that the company is earning more in net profits against the equity investments it receives from shareholders. A company should aim to increase its ROE over time as it is considered a positive value add for shareholders.

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