Everything you need to Know about Return on Equity:
What is Return on Equity?
• Return on equity is a financial formula that measures the rate of return shareholders’ equity or ownership interest of the common stock owner. Return on equity also measures a firm’s efficiency at generating profits from each unit of shareholder’s equity—known as net assets.
• The return on equity formula will show how well a company uses investment funds to generate earnings growth; any company who has a return on equity between 15 and 20% is thought to be doing very well.
What is the Return on Equity Formula?
• The return on equity formula is simply net income after tax divided by shareholder equity. Return on equity is always equal to a fiscal year’s net income, which occurs after preferred stock dividends by before common stock dividends are paid out, divided by the total equity. As is common with a number of financial ratios, return on equity is best used to compare and contrast companies in the same industry.
• A high return on equity will yield no immediate benefits to the underlying company; stock prices are strongly influenced by earnings per share, therefore, the company will be paying more for a higher return on equity. The benefit of a high return on equity comes from the reinvesting of earnings, which in turn, leads to a high rate of growth. Furthermore, the benefit of a high return on equity can come as a dividend on common shares or as a combination of dividends and reinvestment platforms in the company.
• A sustainable growth model will show that when a firm pays dividends to its shareholders, its earnings growth rate will lower. For instance, if the dividend offered was 20%, the growth is expected will only be roughly 80% of the return on equity rate. Furthermore, the growth rate will be lower if the earnings are used to re-purchase shares; if the shares are purchased at a multiple of book value, the incremental earnings will be only a fraction of the return on equity. It is important to remember that, return on equity is calculated from the company’s individual perspective and on the company as a whole.