Return on equity measures a year’s worth of earnings against shareholders’ equity (the difference between a group’s assets and its liabilities). If a firm makes £1m over 12 months and has a shareholders’ equity of £10m, then the return on equity (ROE) is 10%.
ROE can be used to find firms generating large profits from little equity. Such firms are often well regarded as they create shareholder value by creating substantial assets for each pound invested.
But ROE shouldn’t be used in isolation, as highly leveraged firms (those with high levels of debt) will also have high ROE. But they may not show much of a return on total assets (once debt is taken into account). ROE should be looked at alongside a measure of debt.
• Watch Tim Bennett’s video tutorial: What is return on equity?