Return on equity (ROE) is the amount of net income returned as a percentage of shareholders equity.

It measures a corporation's profitability by revealing how much profit a company generates with the money shareholders have invested.


Formula for Return on Equity:
Return on Equity (ROE) = Net income / shareholders' equity


High ROE yields no immediate benefit. Since stock prices are most strongly determined by earnings per share (EPS), a 20% ROE company will cost twice the amount (in Price/Book terms) as a 10% ROE company

The benefit of low ROEs comes from reinvesting earnings to aid company growth. The benefit can also come as a dividend on common shares or as a combination of dividends and company reinvestment.

ROE is less relevant if earnings are not reinvested.

-The sustainable growth model shows us that when firms pay dividends, earnings growth lowers. If the dividend payout is 20%, the growth expected will be only 80% of the ROE rate.

-The growth rate will be lower if earnings are used to buy back shares. If the shares are bought at a multiple of book value (a factor of x times book value), the incremental earnings returns will be reduced by that same factor (ROE/x).

-New investments may not be as profitable as the existing business. Ask "what is the company doing with its earnings?"

-ROE is calculated from the company perspective, on the company as a whole. Since much financial manipulation is accomplished with new share issues and buyback, the investor may have a different recalculated value 'per share' (earnings per share/book value per share).