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Financial Accounting: Help and Review18 chapters | 235 lessons

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Lesson Transcript

Instructor:
*Yuanxin (Amy) Yang Alcocer*

Amy has a master's degree in secondary education and has taught math at a public charter high school.

After watching this video lesson, you will learn how the return on equity helps you as a potential investor determine whether a certain company is worth investing in or not. You'll also learn how companies perform this calculation.

When it comes to the stock market and investing in various companies, you'll want to know whether a particular company is profitable or not. You don't want to invest in a company that isn't profitable, since you won't make money from your investment. But if a company is profitable, then you'll most likely watch your money grow with them. One indication of profitability that you can use is the **return on equity (ROE) ratio**; this ratio tells you how much profit the company can earn from your money.

For example, a return on equity ratio of 1.2 means that for every dollar you put in, the company will earn $1.20. The higher the ROE, the more profitable the company.

So how do companies calculate their ROE ratio? By using this formula:

ROE Ratio = Net Income/ Shareholder's Equity

The net income is the company's income minus dividends and other expenses. The shareholder's equity is the total value of all the stocks that are held by shareholders or investors. For example, if shareholders are holding on to 5,000 stocks at $6, then the shareholder's equity is:

5,000 x 6 = $30,000

What does this ROE ratio number mean? As mentioned at the outset, the ROE ratio, put simply, is a measure of profitability. The higher the ratio, the higher the profitability. The ROE ratio is usually calculated per year but you'll want to check a company's ROE ratio going back several years in addition to its current ROE ratio. This will give you a more accurate picture of how profitable a company is. A company may have a high ROE ratio one year but lower ROE ratios other years. You'll want to see consistently high ROE ratios over the past several years. It's recommended that you look at the ROE ratios for the past 5 to 10 years to get a better picture.

Let's look at an example. Amy's pets, a fictional company, sells only locally sourced handmade pet products, such as handmade collars and handmade clothes. Last year, the company made an income of $500,000. Amy's pets has a total of 20,000 shares of stocks with its shareholders. At $15 the shareholder's equity is 20,000 x $15 = $300,000. Plugging these numbers into the formula (ROE Ratio = Net Income/ Shareholder's Equity), we get this: ROE ratio = $500,000/ $300,000. ROE ratio = 1.67.

With an ROE ratio of 1.67, it means that for every $1 spent by a shareholder, the company earns $1.67

Let's review! The **return on equity (ROE) ratio** tells you how much profit the company can earn from your money. The formula is this one: ROE Ratio = Net Income/ Shareholder's Equity. This ratio tells you how much money the company earns on an investor's dollar. The higher the ROE ratio, the higher the profitability.

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Lesson
31 in chapter 5 of the course:

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Financial Accounting: Help and Review18 chapters | 235 lessons

- The Differences Between Accrual & Cash-Basis Accounting 6:20
- Using Accrual Accounting to Make Financial Statements More Useful 5:47
- Accrued Expenses & Revenues: Definition & Examples 4:30
- Preparing Financial Statements 7:35
- Temporary & Permanent Accounts: Definition & Differences 4:57
- Real Accounts vs. Nominal Accounts: Definition, Differences & Examples 4:55
- Debt Financing: Definition, Types, Advantages & Disadvantages
- Deficit Financing: Definition & Concept
- Differential Cost in Accounting: Definition, Analysis & Formula 5:21
- Direct Labor: Definition & Cost Formula
- Dividend Payout Ratio: Definition, Formula & Analysis
- How to Calculate Asset Turnover Ratio: Formula & Example 5:24
- How to Calculate Current Yield: Definition, Formula & Graph
- How to Calculate Depreciation Expense: Definition & Formula 8:08
- How to Calculate Free Cash Flow: Formula, Analysis & Example
- How to Calculate Future Value: Formula & Example 4:55
- How to Calculate Gross Profit Margin: Definition & Formula 3:24
- How to Calculate Interest Expense: Formula & Example 4:31
- How to Calculate Internal Rate of Return: Definition & Formula
- How to Calculate Net Present Value: Definition, Formula & Analysis 6:04
- How to Calculate Net Profit Margin: Definition & Formula 4:58
- How to Calculate Net Working Capital: Definition & Formula 5:06
- How to Calculate Owner's Equity: Definition, Formula & Examples 4:09
- How to Calculate Payback Period: Method & Formula 6:00
- How to Calculate Profit Margin: Definition & Formula
- How to Calculate Risk Premium: Definition & Formula 5:29
- How to Calculate Sales Revenue: Definition & Formula 3:37
- How to Calculate the Break-Even Point - Definition & Formula 6:12
- How to Calculate the Degree of Operating Leverage: Formula & Example
- How to Calculate the Rate of Return: Definition, Formula & Example 5:04
- How to Calculate the Return on Equity: Definition, Formula & Example 3:31
- Unearned Revenue in Accounting: Definition & Examples 4:46
- Go to Preparing Financial Statements: Help and Review

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