What is return on equity? Well, it's the ability of a firm to generate profits from its shareholders' investments. Quite simply, if shareholders have invested money into a company, we now want to see the ability of the firm to give them a return, and that return is in the form of profits. Which leads us nicely onto how is it calculated? It's net income divided by shareholders equity. Other terms you may see for net income may be net profit or earnings attributable to ordinary shareholders. So why is it important? Well, firstly, it's a measure of excess profits. If we think that net income is after all other costs a company has, because net income is at the bottom of the income statement, after all its other costs, then this looks at the profits that are now available to be paid out to shareholders. If companies have been able to invest their money well and they're able to produce lots of excess profits, then that's good for shareholders. Also, if a company's able to produce excess profits, it may end up with a higher share price or value, where companies have a high proportion of their funding from equity rather than debt. We can see quite a correlation between a higher return on equity and the high value of a company.

Banks are a great example here. Banks have a correlation between return on equity and their price to book multiple i.e. the higher your return on equity, the higher your share price should be. Return on equity is also another good way to appraise management's ability. If management are able to invest in good projects, which return lots of excess profits, then we should get a high return on equity and we would've faith that management are conducting their duties efficiently. Lastly, ROE is fantastic for comparison. If we use ROE or return on equity, just on its own, it wouldn't be of much benefit to us, but we can compare it to the company's return on equity from previous years and we can compare it to other similar companies within the industry. Now, making comparisons to other industries can be problematic. Some industries need very little equity to be invested. For instance, a software company wouldn't need a lots and lots of machinery in order to start up, whereas an oil and gas company would need large scale infrastructure in order to work.