Return on equity (ROE) definition
What is return on equity (ROE)?
Return on equity (ROE) is a measure of a company’s profitability against its equity, expressed as a percentage. In other words, it is how much income the company is generating relative to the amount of capital received from shareholder investments. Think of it as the return a company is getting on its assets.
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ROE calculation
ROE is calculated by dividing a company’s net income by its shareholder equity, and then multiplying the figure by 100 to get a percentage.
ROE example
Let’s say company ABC has a net income (calculated as income minus liabilities) of £100 million and stockholder equity of £450 million. In this example, the ROE would be equal to 22% ([£100 million/£450 million] x100).
What is a good return on equity?
Whether a company’s ROE is good or not will depend on the industry average. So, different figures are considered normal for different industries. For example, a good ROE for the US air transport industry might be 19%, while it could be just 5% for a renewable energy firm.
Generally, traders and investors will look for stocks that have a return on equity ratio that is similar to or above that of its competitors. For example, Delta Airlines ROE in 2018 was 28%, compared to its peer average of 19%.
Alternatively, you can compare the ROE to the long-term average of a stock index. By using this method, you’ll assume that anything below that figure is a poor ROE. If we look at the ROE of the S&P 500 compared to Delta Airlines, we see that the company was outperforming the market in 2018 – with a ROE of 28% compared to 18% for the S&P 500.
What does ROE tell traders?
ROE tells traders if a company is generating enough money from its assets, and is not relying solely on shareholder investments for income. It is also one of the fundamental ratios that can tell you if stock is overvalued or undervalued.
Traders that are looking to hold longer-term positions will usually compare the ROE of one company to another (in the same industry) before they place a trade.
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