Financial Definitions: Return on Equity

When beginning to invest in the stock market, there are a ton of terms to wade through before you can even begin to make a decision on which company is the best fit for your investing needs. Thankfully, even though these financial terms may seem intimidating, they really aren't all that difficult to understand. Let's take a look at one of them: Return on Equity.

Return on Equity

In the finance world, return on equity is usually nicknamed with (you guessed it!) an acronym. Hence, return on equity most often goes by the cool lingo name ROE. Also known as Return on Net Worth (RONW), this little financial term seems to answer to just about anything.

However, the actual meaning behind ROE and RONW is the same: ROE is a measurement of the company's health that can help investors comparison shop for their best investment. A little more in depth, though, we can define ROE as the net income divided by shareholder equity. Yes, I know: that's Greek; let's look at this a little closer.

The ROE Breakdown

Okay, so you know that your equity as the investor is the amount of money that you as a shareholder are entitled at any one time; you own a percentage of the company and are entitled to your share.

The collective shareholder equity is similar in that all of the shareholders together are entitled to a portion of the company. This equity, though, is calculated as total assets minus total liabilities. From there, the ROE is calculated based on this collective shareholder equity. Makes sense so far, right?

Now, when we look at the calculation again (which we remember is the company's net income divided by shareholder equity), we have to define the net income. Basically, net income is the company's profit, or the total revenues minus depreciation, taxes, interest, costs and other expenses.

What Does This Mean for Me?

Once the calculation is complete, you can tell how much profit the company makes from the shareholders' money. Obviously, the more profit a company can make from invested money, the better. Therefore, the higher the ROE for any company in their given industry, the more wisely the company is using the money – and the healthier the company overall.

ROE and other stock balance sheet terms may seem intimidating at first, but they don't have to be. Taking a little time to figure out the meaning of financial terms can be a great investment of your time that can help you invest your money wisely.

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