Return on equity -- or ROE for short -- measures company income relative to stockholders' equity. The higher the return on equity, the more net income the company generates relative to equity levels. If equity levels have fluctuated drastically throughout the year, the company may choose to calculate return on average equity rather than standard return on equity.
Return on Equity Ratio
The return on equity ratio measures how much profit a company earns relative to how much shareholders' equity it has. Investors consider return on equity when making investment choices, because it helps them understand how much more net income the company will produce for every extra dollar of equity it obtains.
Return on equity is a profitability ratio, as are the ratios for return on assets and operating margin. Profitability ratios examine how much income a company earns relative to different factors, like equity, assets and sales.
Calculating Return on Equity
A company's return on equity is its net income divided by stockholders' equity. Net income equals revenue less expenses. Stockholders' equity is the sum of common stock, paid-in capital and retained earnings. For example, a company with net income of $4,000 and equity of $10,000 has a return on equity of 0.4: For every dollar of equity the company has, it earns 40 cents of net income.
Return on Average Equity
If stockholders' equity has varied drastically throughout the year, many companies calculate return on average stockholders' equity in lieu of return on equity. For instance, if shareholders' equity was extremely low for the first 11 months of the year and the company received a large amount of equity in December, the normal return on equity calculation would skew artificially low.
Average stockholders' equity equals net income divided by average annual equity. A company should use beginning equity and ending equity for the year to calculate average annual equity. For example, say the same company had equity of $5,000 at the beginning of the year and equity of $10,000 at the end of the year. Average equity is $15,000 divided by two, or $7,500. With net income of $4,000, the return on average shareholder's equity would be $4,000 divided by $7,500, or 0.533.
Analyzing the Ratio
Generally, a high return on equity is better than a low one. This indicates to shareholders that the company is putting cash infusions from equity to good use and earning additional revenue. However, a low return on equity doesn't always mean the company is performing badly. For instance, say a company just received a large amount of equity and used it to buy equipment to produce more products. Until the equipment is running at full capacity, return on equity may appear low. For this reason, it's best to examine a variety of ratios over a long period to measure company performance.