Return on Equity

Return on equity (ROE) is your net Income divided by your average shareholders’ equity for the period used in preparing your P&L.

It measures the rate of return on the ownership interest (shareholders' equity) of the common stock owners. It measures a firm's efficiency at generating profits from every unit of shareholders' equity. ROE shows how well a company uses investment funds to generate earnings growth. ROEs between 15% and 20% are generally considered good.

Sometimes, it is more useful to use so-called ‘DuPont formula’ (aka ‘strategic profit mode’) for calculating your ROE. In this formula, ROE equals your net margin multiplied by asset turnover multiplied by financial leverage.

Splitting return on equity into three parts makes it easier to understand changes in ROE over time. For example, if the net margin increases, every sale brings in more money, resulting in a higher overall ROE. Similarly, if the asset turnover increases, the firm generates more sales for every unit of assets owned, again resulting in a higher overall ROE.

Finally, increasing financial leverage means that the firm uses more debt financing relative to equity financing. Interest payments to creditors are tax deductible, but dividend payments to shareholders are not. Thus, a higher proportion of debt in the firm's capital structure leads to higher ROE. 

However, you must always keep in mind that net income is not cash. It is your profit on an accrual basis. Therefore, from a financial valuation perspective, you are much more interested in cash ROE measured as your FCF divided by your average shareholders’ equity for the period.