The return on equity ratio or ROE is a profitability ratio measures of how well a company uses investments to generate earnings growth. In other words, the return on equity ratio signifies how much profit each dollar of common stockholders’ equity generates.
Return on Equity = Net Income or Profits / Shareholder's Equity
ROE is especially used for comparing the performance of companies in the same industry. As with return on capital, an ROE is a measure of management’s ability to generate income from the equity available to it. ROEs of 15-20% is generally considered good.
Suppose, ABC company has generated a profit of $100,000 and has about 1,000 shares with stockholders at a value of $50 each. The board decides to issue dividends worth $10,000 to the shareholders.
ROE = (100,000 - 10,000) / (1,000 * 50) = 1.8
ROE is also a factor in stock valuation, in association with other financial ratios. While higher ROE ought intuitively to imply higher stock prices, in reality, predicting the stock value of a company based on its ROE is dependent on too many other factors to be of use by itself.