The return on equity of a company (ROE) is a calculation used to examine how much the company earns on the investment of its shareholders. Dividing a company's net income by the common shareholders' equity results in the ROE figure. Portfolio managers examine return on equity very carefully and use it when deciding whether to buy or sell. ROE is used when evaluating whether a company eats up cash or creates assets. If a company makes $2,500,000 for $10,000,000 invested, then the ROE is 25 percent.
A high ROE figure can mean that the company has a high return on leverage or debt, or that it has a high return on assets. If the company does not have a lot of debt on the books and has a high ROE figure, chances are that management is earning higher profit margins on the assets. If the company is highly leveraged and has a high ROE figure, its return on assets is lower.
Like all financial ratios, the ROE is most effective when used to evaluate a company against its peers. Because return on equity is derived from earnings or net income, an earnings surprise provides a first hint of a change in the ROE trend.
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