Question

What is a return on equity? Why do you think the return on equity is the most popular yardstick of financial performance among investors and senior managers?

Answer 1

Return on equity (ROE) is total percentage return that equity holders expect from an equity investment. The net income is total available funds for equity holders.

Return on equity is calculated as below:

ROE = Net Income / Shareholder’s equity

Net income available should be after tax profits of the firm.

Why return on equity is important yardstick among finance professionals?

1)      The return on equity helps finance managers to understand the performance of the firm in concise ballpark number

2)      The data for net income and shareholder’s equity is very easily available from accounting records

3)      ROE calculation method is very straight forward and it can be easily grasped by any investor who is looking for an investment in a particular stock

4)      If a proper trend analysis is performed the finance managers can get rough idea that how much an investor can earn on their equity investment

5)      DuPont analysis is centered around ROE estimation