Return on equity

The idea

Return on equity, or ROE, relates a business’s profit to the shareholders’ capital supporting it. A common calculation divides profit attributable to ordinary shareholders by their average equity over the period. The exact definition can adjust for other equity instruments, so the company’s stated method matters.

How it works

Equity represents the owners’ residual interest after liabilities. Profit is earned over a period, whereas equity is measured on particular dates. Using average equity helps relate that profit to the capital employed during the period. Changes in profit or in the equity base can therefore change the ratio.

A hypothetical example

Consider a hypothetical company earning $10 in profit attributable to ordinary shareholders while average ordinary equity is $100. Its ROE on that basis is 10%. If the same profit is measured against a smaller equity base, the ratio rises even though profit itself has not increased. The figures are an example, not current results for a named company.

A useful distinction

ROE differs from return on an individual technology investment and from the market return received by a shareholder. Borrowing, losses, distributions and accounting changes can affect equity and the ratio. A high figure alone does not establish that a business is safer or that a particular project caused its performance.

The idea

How it works

A hypothetical example

A useful distinction

Sources

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