Return on equity (ROE) measures how much profit our investment (equity) is generating. It tells you what percentage of every dollar of equity invested in the business was returned to you as profit.
Return on equity is calculated by dividing net profit by shareholders’ equity:
For example, if a company’s net profit was $248 and its shareholders’ equity was $2,457, then its return on equity is:
248 / 2457 = 10.1%
(Excerpts from Financial Intelligence, Chapter 21 – Profitability Ratios)
From an investor’s perspective, ROE is a key ratio. Depending on interest rates, an investor can probably earn 2, 3, or 4 percent on a treasury bond, which is about as close to a risk-free investment as you can get. So if someone is going to put money into a company, he’ll want a substantially higher return on his equity. ROE doesn’t specify how much cash he’ll ultimately get out of the company, since that depends on the company’s decision about dividend payments and on how much the stock price appreciates until he sells. But it’s a good indication of whether the company is even capable of generating a return that is worth whatever risk the investment may entail.