Return on equity (ROE)

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and notes

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Return on equity (ROE)

ROE =

Net income

Average common stockholder’s equity

INTERPRETATION

The return on equity shows the company’s ability to generate profits from its shareholders’ investments (equity). The ratio shows how much profit each dollar of stockholders’ equity generates.

This ratio helps investors understand if they are earning a good return on their money. At the same time, it’s also a way for business owners to evaluate the efficiency of their use of equity.

Note: expanded calculation

Divide net income by average common stockholder’s equity (Do not include preferred dividends. Preferred dividends should be taken out of net income for the calculation)

EXAMPLE

M&M company reported a net income of $100,000 and issued preferred dividends of $10,000 during the year. They also had 10,000 $5 par common shares outstanding during the year.

Return on equity (ROE) = ($100,000 -$10,000) / (10,000 x $5) = 1.80

This means that every dollar of common shareholder’s equity earned about $1.80 this year. Shareholders saw a 180 percent return on their investment.

BENCHMARK: PG, HA, ROT

Return on equity ratios vary by industry, but a 15% to 20% ROE is usually considered good. A 5% ROE would be regarded as low.

The higher the ROE, the better a company converts its equity financing into profits.

Return on equity (ROE) :

ABBREVIATION KEY:

ROT: Rule of thumb
HA: Historical Average (organization’s historical average)
PG: Peer Group average
EB: Economic Benchmark

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