What is the return on equity?
First of all, let us answer the question: what is the return on equity?. ROE (Return on Equity) is a ratio of profitability which shows how much profit the company has managed to make from its equity. In other words: this is the company’s ability to generate profit with the money that shareholders have invested. ROE is also known as “return on net worth” (RONW).
Return on equity formula
Now, when you already know what is the return on equity, you may ask: how to calculate ROE? Let’s find an answer!
The Return on equity formula is based on two variables – you probably have already guessed which ones. We need:
The next step is to calculate the relation between them by dividing the first one by the second, and, in the end, multiplying the result by 100% – don’t forget about this step, as ROE is always expressed as a percentage. Knowing that, you probably won’t have any problems with a derivation of the return on equity formula:
ROE = (net profit / equity) * 100%
How to calculate return on equity?
Now, let’s have a look at how it works in practice. Imagine a company with the following parameters:
- net profit: 34,500 $
- equity: 456,000 $
What will the value of ROE be in this case?
ROE = 34,500 / 456,000 * 100% = 7,57%
What is a good return on equity?
While we already know what ROE is, there’s a next question to pose. It sounds: what is a good return on equity?
The value of ROE should be as high as possible. The higher the ROE of a company, the firmer and more beneficial its situation on the market. Apparently, the best value of ROE is about several dozen percent, but such a level is difficult to reach and then to maintain. A good return on equity is much lower. Economists say that it is about 10-15% – such value is supposed to be likely to keep.
Return on equity vs return on capital
The problem for many people is to notice the differences between indicators which seem to be similar. That’s why we have made a quick comparison return on equity vs return on capital as they are close to each other.
ROCE (return on capital employed) is a ratio which indicates the profitability of the investment in which the whole employed capital of a company is engaged. As opposed to ROE, ROCE considers not only the equity but also liabilities. Thanks to this fact, it is more useful when we want to analyze a company with a long-term debt.