Return on equity is a measure of how efficiently a company can produce earnings.
A company has a certain amount in assets that it uses to produce results and a certain amount it’s expected to produce in revenue and earnings. The company wants to leverage those assets to produce the highest amount in profit it can possibly produce.
Wow, that sounds really complicated. It’s not rocket science. We’re gong to walk you through this.
Let’s start with an analogy.
You have a house. That’s an asset.
You want to rent it out to people while you’re away to make a little extra money.
The house, right now, is worth $100K. Each year, you rent it out to vacationers for $3K a month.
Per year, that’s $36,000, which is 36% of your house’s value. Each year, your return on the asset, your house, is 36%. You’re leveraging this asset to produce earnings (it would actually be less than 36% because of taxes and other things, but you get the point).
Return on equity in corporate finance follows the same idea.
A company has on its balance sheet assets an liabilities. Assets minus liabilities equals net assets, or shareholders equity. Don’t confuse this with the equity value, or market price, of the company. That’s what shareholders ultimately care about. But shareholders equity on the balance sheet shows how much net value currently in the company shareholders own.
A company’s net income, or earnings, is its revenue minus costs for a period, let’s say a year.
Divide net income by shareholders equity to get return on equity.
Now, to see a numeric example and a little snippet of how to compare companies, see the quick video above.