Return on equity – ROE (also known as return on capital) is an efficiency ratio, that measures how much dollars are being earned against each $1 of shareholders’ equity. In other words, investors use return on equity ratio, in order to measure how well a company’s management is utilizing shareholders wealth.
The formula to calculate return on equity (ROE) is:
ROE = Net Income / Shareholders Equity
Where net income is computed after interest and taxes.
Suppose, ABC is a public limited company, with $120 million of net income after interest and taxes, in a recent year. At that time, total capital invested was of $240. By using ROE formula, the solution will be:
ROE = 120/240 = 50%
This means that the company ABC has generated 0.50$ against each one dollar of shareholder’s equity
High return on equity is considered as favorable whereas low unfavorable. Investors compare ROE of different companies to identify past patterns and select most appropriate choice. Although, it is used to gauge efficiency in utilizing shareholders’ wealth but relying on this single measure would not be a good decision because management may manipulate values of net income or shareholder’s equity like issuing bonds may result in the high return on equity despite no change in income.