RETURN ON EQUITY

The return on equity, or ROE, is a way of measuring how successful a company is at leveraging the investments made by the shareholders. It is determined by taking the after-tax income of the company and dividing it by the book value of the company. The book value is determined by taking the total assets of the company and subtracting its liabilities, making it effectively a measure of the shareholders’ investments. The after-tax income is taken after preferred stock dividends are paid out, but before common stock dividends are paid out.

For example, if a company has total income of $50 million, and has a book value of $35 million, then its ROE is 1.429, often expressed as 42.9%. If, on the other hand, the company has a total income of $50 million, and a book value of $75 million, then its ROE is 0.667, or -33.3%. Companies with high ROEs have shown themselves to be effective at using the resources provided by the investors to grow the profitability of the company. Companies with a low ROE, on the other hand, have shown themselves to be less adept at leveraging these investments, and companies with a negative ROE are actively losing money for their investors.

Of course, when analyzing the ROE of a company, it must be put in context. During times of global recession, for example, ROE may flip negative for many companies. This does not necessarily imply that the company’s long-term prospects are poor, simply that it is struggling along with everyone else. Similarly, care must be made not to compare the ROE of companies in very different industries. Because different industries have radically different margins; what is low by one industry’s standards may be high by another. Generally, ROE should only be compared within the same industry, or within industries that have similar ROE averages.