A company's return on equity (ROE) reflects the productivity of the net assets (assets minus liabilities) a company's management has at its disposal.
Whenever a company generates profits, there are four main things it can do with that moolah. It can:
- Pay shareholders a dividend
- Pay down debt
- Buy back shares of company stock
- Reinvest in operations
Return on equity reveals how effectively reinvested earnings and capital that shareholders originally invested in the company are used to generate additional earnings. For example, profits might be used to acquire another company. Or a new factory might be built, upping the firm's output and sales.
To calculate return on equity, take one year's (or four quarters') worth of earnings (often referred to as "net income") from the income statement. Next, look at shareholders' equity, on the balance sheet. Remember that net income reflects income generated over a period of time, whereas shareholder's equity listed on the balance sheet reflects a value at one point in time. You want to use a shareholder equity figure that covers the same period of time as the net income figure. So you'll average two shareholders' equity numbers, from the beginning and end of that period, adding them and then dividing by two.
To finally arrive at the ROE, divide the year's earnings by the average shareholders' equity. (Whew!)