What is the Return On Equity Ratio?

The Return on equity or ROE is a financial ratio that measures the return based of the equity of the stock. This is considered to be one of the best fundamental indicators by many.

The Formula is

ROE= Net Income / Total average equity

Generally you want to see a stock with a high Return on equity. You would think that all companies can be compared evenly with this rate. This is not always the case however. Some industries will have a higher ratio while others will naturally come out with a lower ratio.

To get a better understanding of how well a company is performing this ratio can be compared with other ratios of different companies in the same or similar industry groups. If the company has a high ratio compared to other companies in its same industry group it is considered to be good. If it has a low ratio when compared with those same companies it is considered to be bad.

This number should not be calculated annually if the company is a seasonal business. This means if the company only makes sales during spring and summer it should be calculated with those quarters. If it does make sales all year it should be calculated annually.

This ratio assumes that a company with a high ROE will grow faster when they reinvest their profits then one with a lower ROE (The less money you need to grow the faster you can grow). Needless to say if a company does not reinvest its profits this ratio becomes less important.

Other Ratios

Using other ratios in combination with this can help you to paint a picture of a company’s financial status. Here are a few ratios that can be used to show how strong or weak a company is.

Levered Free Cash Flow – This indicator shows how much cash flow a company has after its normal expenses.

Solvency Ratio - This ratio looks at a company’s ability to meet its debts.

Discounted Cash Flow - This ratio looks at a company’s estimated future profits.