Return on Equity

Return on equity (ROE) evaluates the profitability of a company by measuring a company’s net profit relative to the amount of shareholder equity invested in the business and is key for valuing a company. ROE is expressed as a percentage and is calculated by dividing the company’s net income by its shareholder equity.

Source: Investopedia

ROE highlights how effectively a company uses its investors’ capital to generate profits. High ROE indicates that the company is generating a significant amount of profit for each dollar of shareholder equity invested. A company with high profit margins and efficient asset management will typically have a higher ROE than a company with lower profit margins and less efficient asset management.

For example, on asset management, a company can increase its earnings per share indefinitely by investing all free cash in treasury bills. This is inefficient, so a company instead can pay dividends to distribute cash, reinvest in growth assets to boost net income, or repurchase stock to shrink the equity base and boost ROE. The diligent investor will catch this inefficiency through annual decline in ROE.

The investor should compare ROE against the company’s debt position. High ROE but high debt means the company is only obtaining high ROE through leverage. (for example, buying a house with 5% down vs 30% down will show a higher ROE, but this is only through more leverage). High ROE with responsible debt highlights a strong economic position.

Investors should not only view the static ROE number but also monitor the change in that figure over subsequent periods. An increasing ROE means a company is creating more value for shareholders.