For publicly traded companies and in investment terms the return on equity (Also abbreviated as ‘ROE’) is a way to measure the amount of net profits from a business as it relates to the total value of the equity of the enterprise. ROE is a measurement of how efficiently a business uses its asset value to create cash flow and growth.
ROE is defined as the annual net income that is left after preferred stock dividends are paid but before common stock dividends are distributed then divided by the total equity value of the company (Equity value is the market capitalization based on the price of outstanding shares excluding preferred shares multiplied by share count). The sum total is expressed as a percentage of net income to equity.
The return On equity formula is:
ROE is can also be considered a “return on net worth.” This ratio measures how much money that a company earns per every shareholder’s dollar.
ROE is a fundamental tool in investing that allows you to compare the net profits of different companies that operate in the same market sector or industry. ROE shows the earning power that a company has in relation to the total value of the equity size of the company.
A ROE of 15-20% is considered a good metric by most investor standards. It is one of many fundamental ratios considered in the measure of a stocks value to an investor. ROE has to be used with other factors like P/E, sales growth, and profit margin to understand its value in stock pricing and fundamental company valuation.