Return on Equity (ROE)

ROE answers a question every shareholder cares about: how hard is our money working? Shareholders' equity is the owners' stake on the balance sheet, made up of the money they put in plus profits kept in the business over the years. Dividing a year's net income by that stake gives a percentage return.

Suppose a company earns net income of 120,000 in a year and its shareholders' equity is 800,000. Its ROE is 15%. For every 100 of equity, the business produced 15 of profit for its owners. A competitor earning the same 120,000 on equity of 1,200,000 has an ROE of only 10%, so it needs more of its owners' money to produce the same profit.

ROE can be pushed up by borrowing. If a company replaces some equity with debt, the same profit is spread over a smaller equity base and ROE rises, but so does the risk of struggling to repay. Share buybacks have a similar effect, because they also shrink equity.

A high ROE is therefore not automatically good news. Analysts compare it with similar companies, check how much debt sits behind it and often break it into margin, asset use and leverage to see what is really driving it.