Return on equity is a measure of how efficiently the management of a company generates shareholder value per dollar invested. A high return on equity means that the management has been relatively effective at generating perceived market value for shareholders.
Return on equity is equal to the change in market value of a company from one accounting period to the next, divided by the total equity in the company at the beginning of the accounting period. For example, a company with equity, or net worth, of $1 million at the beginning of the year, that increases its market value from $5 million to $5.5 million over the course of a year, has a return on equity of 50 percent, or $500,000 divided by $1 million.
Analysts use return on equity to compare the performance of different company management teams in similar industries. The metric is useful in the context of other types of valuation metrics.
Return on equity is a backward-looking statistic, and does not necessarily predictive of future results. By itself, return on equity does not take into account risk. A management team may be able to boost its return on equity numbers in the short term by borrowing large amounts of money -- a technique called "leverage," or "gearing." This can boost returns, but it also magnifies losses -- if the investments made with the borrowed money do not pan out.
Alternative Valuation Metrics
One alternative to measuring return on equity is return on capital. This metric measures the shareholder return on all invested assets, including bonds and other forms of borrowed money. With this metric, analysts use net operating earnings, before debt service payments, for the calculation. Any assets invested are accounted for at their current book value, as opposed to their acquisition costs. This approach takes depreciation into account.