What does 'Return on Equity' mean?

Return on Equity (ROE) is a financial ratio that measures the profitability of a company in relation to the equity of its shareholders. It represents the amount of net income a company generates for each dollar of shareholder equity.

ROE is calculated by dividing a company’s net income by its shareholder equity. Net income is calculated by subtracting a company’s expenses, including taxes, from its revenues. Shareholder equity is calculated by subtracting a company’s liabilities from its assets. The resulting ratio is typically expressed as a percentage.

ROE is an important metric for investors because it helps them to evaluate how effectively a company is using the money that is invested in it by its shareholders. A high ROE indicates that a company is generating strong profits relative to the amount of shareholder equity it has, which could suggest that the company is well-managed and that its shares are undervalued. A low ROE, on the other hand, could indicate that a company is not performing as well as it could, and that its shares may be overvalued.

However, it’s important to note that when comparing ROE across different companies, it’s important to look at the ROE in the context of the industry and the company’s size. Because different industries have different characteristics, a company in one industry might be considered to have a high ROE, while a company in another industry might be considered to have a low ROE. Also, larger companies may have lower ROE due to the economies of scale that can make it more difficult for them to grow.

Additionally, it’s also crucial to look for the cause of the company’s high ROE, as it could be caused by an unusually high level of leverage (debt financing) which makes the ROE artificially high, but also increases the company’s risk.

ROE is not only of value for investors, but also for company management and board of directors as well, since it provides insight on how well management is utilizing the shareholders’ resources, and whether it is achieving its goals for return on investment.