Calculating Return on Equity
For publicly traded companies, the relationship of earnings
to equity or Return on Equity is of prime importance since management must
provide a return for the money invested by shareholders. Return on Equity is a
measure of how well management has used the capital invested by shareholders.
Return on Equity tells us the percent returned for each dollar (or other
monetary unit) invested by shareholders. Return on Equity is calculated by
dividing Net Income by Average Shareholders Equity (including Retained
Earnings).
EXAMPLE - Net
Income for the year was $ 100,000, total shareholder equity at the beginning of
the year was $ 550,000 and ending shareholder equity for the year was $ 300,000.
Return on Equity is calculated by dividing $ 100,000 by $ 425,000 (average
shareholders equity which is $ 550,000 + $ 300,000 / 2). This gives us a Return
on Equity of 24%. For each dollar invested by shareholders, 24% was returned in
the form of earnings.
Return on Equity is one of the most widely used ratios for
publicly traded companies. It measures how much return management was able to
generate for the shareholders. The formula for calculating Return on Equity is:
Net Income / Average Shareholders Equity
