Return on equity is a ratio that investors commonly use to measure the efficiency of a particular company. It shows the annual return investors are getting from their stake in a company, expressed as a percentage of the original investment. The basic calculation of return on equity is relatively simple.
To calculate return on equity you need to know the company’s net income and the average value of shareholders’ equity over the year. For instance, assume a company has net income in a given year of $50 million. At the beginning of the year, assume the shareholder equity was $150 million, and at the end it was $225 million.
First you must find the average shareholder equity, so add the figures from the beginning and end of the year, then divide by two. In the example this would be 150 million + 225 million = 375 million/2 = 187.5 million. Then divide the net income figure by this average equity. Thus: 50 million/187.5 million = ,267 or 26.7 percent.
ROE varies widely across different industries, depending on various business models. Some companies in capital-intensive industries, such as manufacturing, will have a relatively low ROE, while service and retail industries may achieve a higher figure. Therefore it usually only makes sense to compare ROE among companies in the same sector or industry. It can also be very instructive to look at a company’s ROE in successive years to see if it shows a trend of rising or falling.
As with any single ratio, ROE only tells you part of what you need to know about the financial health of a company. However, it is one of the most important calculations you can perform from a company’s balance sheet. It can reveal how efficiently a company uses its capital, and how well the management creates value for shareholders. It can be significantly more informative than simply looking at a company’s quarterly or annual earnings.