Why is return on equity such an important measure for a company?

Why is return on equity such an important measure for a company? How does a good ROE help prove that the company is performing well?

Response:

One of the most important profitability metrics is Return on Equity, or ROE for short. ROE reveals how much profit a company earned in comparison to the total amount of shareholder equity found on the balance sheet. Shareholder equity is equal to total assets minus total liabilities. It’s what the shareholders “own”. Shareholder equity is a creation of accounting that represents the assets created by the retained earnings of the business and the paid-in capital of the owners.

Return on Equity is an important measure for a company because it compares it against its peers. With return on equity, it measures performance and generally the higher the better. Some industries have a high ROE as they require little or no assets while others require large infrastructure builds before they generate profit. For this reason ROE is best used to compare companies in the same industry. Performance ratios like ROE, concentrate on past performance to get a gauge on future expectation.

The formula for Return on Equity is: Net Profit ÷ Average Shareholder Equity for Period = Return on Equity

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A business that has a high return on equity is more likely to be one that is capable of generating cash internally. For the most part, the higher a company’s ROE compared to its industry, the better. This should be obvious to even the less-than-astute investor If you owned a business that had a net worth (shareholder’s equity) of $100 million dollars and it made $5 million in profit, it would be earning 5% on your equity ($5 ÷ $100 = .05, or 5%). The higher you can get the “return” on your equity, in this case 5%, the better.

The higher the ROE, the more easily, the company will be able to raise money for growth.

By Stephen Karpin, General Manager, CommSec

Important Information
The views expressed in this article are those of Stephen Karpin, a representative of Commonwealth Securities Limited (CommSec) ABN 60 067 254 399 AFSL 238814. Commonwealth Securities Limited (CommSec) ABN 60 067 254 399 AFSL 238814 is a wholly owned but non-guaranteed subsidiary of the Commonwealth Bank of Australia ABN 48 123 123 124 and a Participant of the ASX Group and the Sydney Futures Exchange. As this information has been prepared without considering your objectives, financial situation or needs, you should, before acting on this information, consider its appropriateness to your circumstances and if necessary, seek appropriate professional advice.