The Return on Equity Ratio: Formula, Calculation & Analysis

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  • 0:04 Return on Equity
  • 2:23 Analysis
  • 4:40 Lesson Summary
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Lesson Transcript
Instructor: Martin Gibbs

Martin has 16 years experience in Human Resources Information Systems and has a PhD in Information Technology Management. He is an adjunct professor of computer science and computer programming.

In this lesson, we'll explain the formula needed to calculate the return on equity ratio. We'll also look into how the ratio can be used to analyze a company's ability to generate profit.

Return on Equity

Let's say you have inherited a sum of money and want to invest it in a stock. But which stock? There are several formulas and ratios you can use to help figure this out. One of these ratios is the return on equity ratio, which shows how well a company creates profits from an investment. Basically, it's a profitability ratio, or a measure of the ability to generate profit. In a publicly-traded company, equity is the amount of stock owned by shareholders.

If you want to know how much of your investment is going towards generating profits, you can calculate it using the formula for the return on equity ratio, which is:

  • Return on Equity = Net Income / Shareholder's Equity

So, while you're investigating stocks, you come across a company, Tall Oak Toys, with the following data on its recent income statement and balance sheet:

  • Net Income = $12,500,000
  • Total Shareholder Equity = $52,750,000

Thus, its return on equity ratio is $12,500,000 / $52,750,000 = 0.24.

Is this good or not? What this means is that, for $1 in shareholder equity, the company produced almost $0.25 in profit. This is really good for you, since it equates to a nearly 25% return on your investment. Tall Oak Toys looks like a good investment.

Okay, let's look at another example, Blue Nettle Games, which has:

  • Net Income = $15,000,000
  • Total Shareholder Equity = $10,250,000

After calculating the ratio ($15,000,000 / $10,250,000), we get 1.46. At first, you might think the ratio is bad, that it should always be under 1. But think about this: It means that for every $1 in shareholder equity, Blue Nettle Games earned $1.46. That's a 146% return! This company is likely growing. Or is the number just too high? Let's find out.

Analysis

So which company should you invest in? The growing company with the 25% return, or the off-the-charts 146% return? A high return on equity ratio can indicate a company is growing, and just doesn't have the shareholder equity of an established firm. Or it can be an anomaly in an otherwise poor history of performance. Right now, we only have the data from one year. Unfortunately, we can't tell you which stock is the best without some more data to help make the decision.

We should really go back and get an average from the past five or even ten years to see where we sit. Perhaps the 146% gain is a fluke, and the company has not seen any return in the past years. What if the past five years had looked something like this?

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