Wednesday, 25 January 2012

Return on Equity (ROE)

Return on Equity Definition:
Return on equity, defined also as return on net worth (RONW), reveals how much profit a company earned in comparison to the money a shareholder has invested.

Return on Equity Explanation:
Return on equity, explained as a measure of how well a company uses investment dollars to generate profits, is more important to a shareholder than return on investment (ROI). It tells investors how effectively their capital is being reinvested. A company with high return on equity is more successful to generate cash internally. Investors are always looking for companies with high and growing returns on equity. However, not all high ROE companies make good investments. The better benchmark is to compare a company’s return on equity with its industry average. The higher the ratio, the better a company is.

Return on Equity Formula:
The return on equity formula listed below forms a simple example for solving ROE problems.

Return on Equity Ratio =
Net income ÷ Average shareholders equity

When solving return on equity, equation solutions only form part of the problem. One must be able to apply the equation to a variety of different and changing scenarios.

Return on Equity Calculation:
Average shareholders' equity, or return on equity, is calculated by adding the shareholders' equity at the beginning of a period to the shareholders' equity at period's end and dividing the result by two. No simple return on equity calculator can complete the job that a solid understanding of ROE can.

Example: a company has $6,000 in net income, and $20,000 in average shareholders’ equity.

Return on equity: $6,000 / $20,000 =30%

This means that a company has $0.3 of net income for every dollar that has been invested by shareholder.

Return on Equity Example:
Melanie, after seeing success in her corporate career, has left the comfortable life to become an angel investor. She has worked dilligently to select companies and their managers, hold these managers accountable to their promises, provide advice and mentoring, and lead her partners to capitalization while minimizing risk. At this stage, Melanie is ready to receive her pay-out. Melanie wants to know her Return on Equity ratio for one of her client companies.

Melanie begins by finding the net income and average sharholder's equity for the venture. Looking back to her records, Melanie has invested $20,000 in the business. Her net income from it is $6,000 per year. Performing her return on equity analysis yields these results:

Return on equity: $6,000 / $20,000 =30%

Melanie is happy with her results. Purposefully starting small, she has built the experience and confidence to be successful. She can now move on to bigger and better deals.


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