Return on Equity (ROE) is a measure of a company’s profitability. It is calculated as:

\(\frac{Net \:Income}{Shareholder’s\: Equity}\)
In practice, ROE is one of the basic ratios used by investors to compare the profitability of a company either to that of peer companies or to the industry average for the same time period. The idea behind this profitability ratio is that companies with a high ROE will be able to use shareholder equity more efficiently to generate profits and thus provide a higher return on investment.

All components of the ratio can easily be identified. While net income features in a company’s income statement, shareholders’ equity is part of the balance sheet.

If we use the financial data released by Ford Motor Co. for 2005, for example, the ROE for the year would be:

If we compare this to another car maker’s figures for the same year, such as DaimlerChrysler, we will see that despite DaimlerChrysler’s higher net income ($2.8 billion compared to $2.0 billion), its ROE is lower as a result of a much larger total shareholder equity ($36.4 billion compared to $12.9 billion):

These calculations show that Ford’s ROE of 15.6% is twice as high as DaimlerChrysler’s 7.8%. At first glance, this would indicate that Ford has a much greater ability to use the investments made by shareholders to generate earnings. However, there is a fundamental problem with ROE in that the ratio’s denominator – total shareholders’ equity or average common equity – represents the total of a company’s assets less its total liabilities. This means that ROE does not take the company’s liabilities into consideration. In other words, how much borrowing does the company have? This is called gearing or leverage. The question that needs to be asked is: how highly geared or how highly leveraged is the company?

If a company funds expansion by raising debt instead of issuing equity, the net income might rise as a result, but shareholder equity will stay the same and thus lead to a higher ROE, providing the additional return exceeds the interest cost of the increased borrowing. Hence, a high level of debt can inflate ROE.

In order to take liabilities into consideration, other ratios, for example Return on Assets (ROA), can be used. ROA puts the net income in relation to the company’s total assets (regardless of how it is funded). If we again use the example of the two automobile manufacturers:

Ford’s ROA is calculated as:

Whereas DaimlerChrysler’s equivalent ROA is:

Even though DaimlerChrysler has a considerably lower ROE than Ford, its ROA of 1.4% is nearly double the amount of Ford’s 0.75% ROA. This can be explained by the different levels of debt and liabilities that the companies carry on their balance sheets. DaimlerChrysler’s total liabilities of $165 billion are significantly lower than Ford’s at $255 billion.

Hence, to use ROE effectively, it is important to also consider the level of debt a company has. But for a company with little or no excess debt, the ROE ratio is a good indicator of the company’s ability to grow.