Return on Equity (ROE)
Return on equity calculates the rate of return on the ownership interest i.e. shareholders' equity of the common stock owners. It evaluates a efficiency of firm at generating profits from every unit of shareholders' equity . It is also referred as net assets or assets minus liabilities. Return On Equity represents how well a company utilizes investment funds to get earnings growth. Return On Equity between 15% and 20% are desirable.
High Return On Equity yields no immediate benefit. Since stock prices are strongly decided by earnings per share, investor will be paying twice as much in Price/Book terms for a 20% return on Equity Company as for a 10% return on Equity Company.
The gain comes from the earnings is again invested in the company at a high return on equity rate, which in turn renders the company a high growth rate. The gain can also come as a dividend on common shares or as a combining dividends and reinvestment in the company. Return on equity is assumed irrelevant if the earnings are not reinvested.
The sustainable growth model displays when firms pay earnings growth lowers and dividends. If the dividend payout is 30%, the growth expected will be only 70% of the return on equity rate. The growth rate will be low if the earnings are utilized to buy back shares. If the shares are bought at a multiple of book value , say 3 times of book vales, the gradually increasing earnings returns will be only fraction of return on equity. New investments may not be as fruitful as the existing business.
The return on equity is computed from the company's point of view, on the company as a whole. Since much financial handling is accomplished with new share issues and buyback, always recalculate on a per share basis, i.e., earnings per share/book value per share.
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