What Does
Return On Equity Mean?
Return on equity (ROE) is defined as the ratio of net income returned by a firm during a specified period (normally an accounting year) to its owners or stockholders. ROE is a simple measure of the past and current profitability of equity investments in the firm. It is calculated by dividing the net profit by the weighted average of equity. ROE may also be calculated by dividing net income by shareholders’ equity. If there was a reduction in the equity or an increase in paid-up equity anytime during a financial year, then the weighted average must be calculated. If there is no change in equity during the entire period, equity of the first day of the year is used in the calculation.
ROE measures a firm’s capability and efficiency in generating adequate surplus revenues after meeting expenditures and liabilities. Consistent and growing ROE over a period of time generally enhances a firm’s value.
Return on equity is also called return on net worth.
Divestopedia Explains Return On Equity
ROE represents a company’s past – and, to some extent, current – profitability. It may or may not indicate future profitability. However, it can be applied as a parameter for inter-firm comparisons in a single industry or a group of similar industries. Within an industry, the firm that has an above average ROI gets investor attention. Such companies are likely to survive even during a recession. Consistently high ROE can also attract buyers.
A firm that has a consistent record of high ROE is likely to generate higher cash flow internally, which is needed for modernization and capacity creation, as well as for rewarding shareholders with dividends and bonus shares.