Return on equity

A ratio compares two figures to reveal something neither number shows on its own. Return on equity compares how much profit a company generates against how much shareholders have invested in the business, showing how efficiently that capital is being put to work.

Return on equity divides net income by shareholders equity. It shows how many cents of annual profit are generated for every dollar shareholders have invested.

The formula is: Net income / Shareholders equity.

A higher ROE generally signals a more efficient use of shareholder capital, though it should never be read in isolation. Two companies can post the same ROE for very different reasons, one by genuinely generating strong profits from a lean capital base, the other by taking on heavy debt that shrinks the equity in the denominator without actually improving the underlying business. Decomposing ROE through the DuPont framework, net margin multiplied by asset turnover multiplied by financial leverage, reveals which of those is actually driving the number.

ROE is most useful compared across time for the same company or against close industry peers, since capital intensity and what counts as a normal ROE vary enormously between industries.