The return on equity ratio or ROE is a profitability ratio that measures the ability of a firm to generate profits from its shareholders investments in the company. In other words, the return on equity ratio shows how much profit each dollar of common stockholders’ equity generates.
So a return on 1 means that every dollar of common stockholders’ equity generates 1 dollar of net income. This is an important measurement for potential investors because they want to see how efficiently a company will use their money to generate net income.
ROE is also an indicator of how effective management is at using equity financing to fund operations and grow the company.
Most of the time, ROE is computed for common shareholders. In this case, preferred dividends are not included in the calculation because these profits are not available to common stockholders. Preferred dividends are then taken out of net income for the calculation.
- Compares the profitability of a company to that of other firms in the same industry.
- Useful to measure efficiency of management in using Equity
The ROE is a better gauge than simple EPS of how a company is deploying its capital to build a profitable business. The higher the ROE, the more wealth the company is creating for its shareholders, and the better return they can expect from their investment. A company’s ROE should be compared to that of its competitors and other companies in the same sector, whereas EPS and P/E ratios are better used as a gauge of whether the shares themselves are over or undervalued. – (See more at:http://wiki.fool.com/The Difference Between a Return on Equity Earnings per Share)