Return On Equity In A Nutshell
Return on Equity indicator provides good insight as to how shareholders dollars are being used by the firm. If a company's ROE grows over time, it's a good sign that its management has found ways to generate income without much of new capital moving forward. On the other hand, if company's ROE is continuously falling, it could be a sign of upcoming financial distress.
Return on equity is one of the most important measures of the profitability of a firm. Higher ROE are generally favorable to investors because it may imply that the company is more efficient in generating profits. Investors should always check the trend in ROE over time because relying solely on ROE for investment decisions is not always safe. For example it can be artificially influenced by the management or corporate insiders to increase ROE even if revenues and profits remain constant.
Closer Look at Return On Equity
Return on Equity (ROE) shows how efficiently a given company uses shareholders money to generate revenues, profits, and grow the firm. Investors want to see significant returns on their invested capital because this would indicate that the company is using their money effectively. In general the higher the ROE to more satisfied investors are with the current management, so the higher ratios are almost always better than lower ratios. However, since every industry has different criteria for income and profit expectations, ROE cannot be used to compare companies outside of their sectors and industry classifications. Also, company growth that can be derived from a higher ROE does not always get passed onto the investors. If the company decides to retain these profits, the shareholders will only realize this gain by having an appreciated stock and will rely on market timing strategies to realize their investments.
Return on equity is calculated by taking all earnings and dividing them by the average shareholder equity for that accounting period. The income or loss numbers usually come from the company's most recent filing with the SEC or simply from the latest Income Statement. The shareholder-equity numbers can be found on the balance sheet and that represents the assets that the business has generated.
Note that many investors like to also calculate both the beginning and ending ROEs, which allows them to determine the change in profitability over the period. This is an important indicator of company future profitability. To calculate the change in return on equity for a specified period investors use the shareholders equity numbers from the beginning of that period as a denominator to determine the beginning Return on Equity. Then, the end-of-period shareholders equity can be used as the denominator to determine the ending ROE. This also can demonstrate that companies with a negative ROE may not always be a bad investment as their future my look much brighter overall.