Return on Equity

Return on equity is a fairly strong measure of company profitability which displays how much profit is generated for every dollar of equity invested in the company. Return on equity is simply Net Profit divided by Shareholder’s Equity. For non-financial firms, you should look for firms with Return on Equity at 10% or above. You should prefer firms with over 20% Return on Equity. Return on Equity definitely needs to be higher than the low rates of return on “guaranteed” investments such as government bonds, since companies are inherently more unstable than governments.

However, firms with an excessive amount of Return of Equity may be distorted by other factors which include changed or disrupted capital structures. Return on Equity that is unreasonably high for an industry usually should not be believed. If an industry average ROE is 7% and a firm has a Return on Equity of 74%, there is probably something wrong worth researching. If you find an abnormally high number, investigate before investing.

Financial firms have different rules for Return on Equity. Financial firms (banks specifically) require higher bars due to the nature of their business. This is mostly due to how they generate returns on assets. They borrow money to generate earnings, known as leveraging. These distort ROE, so when comparing financial firms, you should seek considerably higher Returns on Equity.