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All trading basics

Return On Equity - ROE

Return on equity = Net Income ÷ Shareholder's Equity

Indicates what return a company is generating on the owners' investment.

Things to remember

  • If new shares are issued then use the weighted average of the number of shares throughout the year.
  • For high growth companies you should expect a higher ROE.
  • Averaging ROE over the past 5-10 years can give you an idea of the historical growth.
Balance Sheet
Consolidated balance sheet and consolidated income statement for Cory’s Tequila Co. for 1998 and 1999
Income Statement
Consolidated income statement for Cory’s Tequila Co. for 1998 and 1999

For Cory's Tequila Co.: $2,096 ÷ $11,678 = 0.18

Return on Equity Analysis:

Sometimes ROE is referred to as stockholder's return on investment, it tells us the rate that shareholders are earning on their shares. Cory's Tequila Co. is earning a very respectable 18% on shareholder's equity. But ROE is often misunderstood, for example if the return on equity is 10% then ten cents of assets are created for each dollar that was originally invested. Companies that generate high returns relative to their shareholder's equity are companies that pay their shareholders off handsomely, creating substantial assets for each dollar invested. These businesses are more than likely self-funding companies that require no additional debt or equity investments.