What is return on equity?

What is return on equity and why is it important?

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Return on equity is a measure of profitability, which calculates the return which a company is able to generate with its shareholders equity (cash).

It is widely considered one of the most important metrics to determine company performance and a firm’s continued ability to generate satisfactory returns. Return on equity can be calculated using the following formula:

Net Income/ Shareholders Equity

A firm earning $10,000 per year with $100,000 shareholders capital invested would be earning 10% on equity.

Why is return on Equity Important?

A high return on equity means that a business is able to reinvest funds into the business to grow operating earnings without requiring additional equity (cash) from their shareholders. It means that the business will be less dependent on borrowing money as they earn consistent high returns on their initial investment. The return on equity metric enables an investor to gain insight into the performance of a company as it can be seen how a company manages its money, including every year鈥檚 prior savings (retained earnings). It also enables an investor to assess how successful the firm is at investing its money into other business segments, which often deviate from its core business.

Businesses which have high returns on equity

An exhaustive study of American businesses by Dr J.B Farewell, present extensive evidence that businesses which are able to earn high returns on equity, earn materially higher returns than the market in general. There is significant evidence to suggest that there is a correlation between return on equity and returns as a whole. The top 8 firms in the Dow Jones Industrial average by return on equity, returned a compounded 18.4% per year over a 20 year period, compared to firms with an average return on equity, who returned just 12%.

It should be noted however, that some firms may earn very high returns on equity, due to having very large debts outstanding and consequently low net equity. Returns on equity, should therefore be analysed in context with a firm’s return on assets.

Conclusion

This easy to calculate metric is one of the most effective measures of a firm鈥檚 performance over time. Firms which continually earn high returns on equity tend to grow their owner鈥檚 earnings consistently over time and (often) have superior money management teams.

Motley Fool contributor mpinto has no position in any of the stocks mentioned. The Motley Fool Australia has no position in any of the stocks mentioned. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Scott Phillips.

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