Return on equity

Of all the money a company makes, shareholders care most about what it earns on their stake. Return on equity measures exactly that.

Return on equity is a measure of profitability that expresses a firm's profit as a proportion of the shareholders' equity invested in it. It answers how much profit the company generates for each unit of the owners' money, and it is one of the most closely watched indicators of how well a firm uses its shareholders' capital.

Profit on the owners' stake

Return on equity focuses on the return to the owners specifically. By dividing profit by the equity that shareholders have invested, it measures how effectively the firm turns the owners' capital into profit. A high return on equity means the company is generating substantial profit from a given base of shareholder funds, which is generally a sign of an efficient and profitable business, while a low one suggests the firm is making poor use of the capital its owners have committed.

The leverage caveat

Return on equity comes with an important catch: it can be boosted by debt as well as by genuine performance. Because equity is only part of a firm's financing, a company can raise its return on equity by using more borrowed money and less of its own, magnifying the return on a smaller equity base. This means a high return on equity may reflect heavy leverage rather than operational excellence, and the same leverage that flatters it in good times amplifies losses in bad. A high figure should therefore always be read alongside how much debt produced it.

Reading it well

Because return on equity blends profitability, efficiency, and leverage, it is most useful when decomposed and compared in context. Analysts break it into components, profit margin, asset turnover, and leverage, to see what is driving it, and they compare it across time and against peers, since a good level varies by industry. A return on equity that is high purely because of debt is a different and riskier thing from one built on strong margins and efficient operations, and the measure rewards being understood rather than taken at face value.

Return on equity is a headline gauge of how well a company rewards its owners, measuring the profit wrung from each unit of shareholder capital. Its prominence is deserved, since it speaks directly to the owners' interest, but so is the caution it requires, because leverage can inflate it without any real improvement in the business, making it a number that is informative when understood and misleading when taken alone.