Financial Education

Return on Equity (ROE) measures how well a company uses the capital provided by its equity investors. Since equity investors are entitled to what profits remain after interest is paid to debtholders and taxes are paid to the government, net income is the appropriate measure of profit.

ROE = (Net income)/(Average total equity)

For Plantronics in 2006:

	2006	2005
Net income	81,150	97,520
Shareholder equity	435,621	405,719
Average shareholder equity	420,670
Return on equity	19.3%

A return on equity of 19% indicates that the company generates $19 of earnings for every $100 that has been invested by shareholders over time – the higher the ROE the better.

There are two circumstances in which the investor may wish to adjust either the numerator or the denominator in computing this ratio. The first is when the company has issued preferred stock, which is a hybrid security similar to both debt and equity. In this case, the numerator should deduct any preferred dividends from net income.

The second case in when book value differs significantly from market value. While calculating return on equity using book value adequately describes how well management has made use of the investment proceeds it received in the past, it does not necessarily indicate how much an investor can earn on his or her equity investment today. To estimate the potential return for today’s investor, the market value could be used in the denominator rather than the book value. In such cases, the current value rather than an average value can be used. Note that earnings over the market value of equity is also known as the earnings yield and is the inverse of the P/E ratio.

For more information, see all articles on: Financial Statement Analysis, Fundamental Analysis, Investing in Stocks, Investment Returns, Ratio Analysis

See also:

Creating an Index Portfolio Using Total Return Swaps

The 3-Stage DuPont Model

Estimating the Required Return on a Stock Using the Bond-Yield Plus Risk Premium Method

The Weighted Average Cost of Capital (WACC)

Residual Income