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What Is Return on Equity?

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  • Written By: Ken Black
  • Edited By: Bronwyn Harris
  • Last Modified Date: 13 July 2014
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Return on equity is the net income a company produces divided by the shareholders’ equity. This is one of the key measures of profitability for a company and is a good way to compare different companies when it comes to questions of profitability. In addition to the primary formula, there are several others that may also be used from time to time to find the return on equity.

Another common return on equity measurement is to take the net income and subtract that by the common equity, after divided by the preferred dividends. This is often referred to as the return on common equity. This formula can provide a slightly different picture than the more simplified formula and may be preferred by some investors. In most cases, common dividends are still included in the return on equity.

There is also another formula that is sometimes used to determine the return on equity. The DuPont formula takes into account three major areas. Sales are divided by net income, which is multiplied by total divided by sales, which is multiplied average stockholder equity divided by total assets. While this formula is most complex, it takes more into account and some may believe it offers a more complete picture.

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Determining the return on equity over a certain period of time is important to spot the latest trends, which investors may wish to consider before deciding where to put their money. Taking the shareholders’ equity from the beginning of the period and running the formula, then taking the shareholder’s equity at the end of the period and running the formula will give a good comparison. The change in profitability should be easily seen when that is completed.

Investors should consider a number of different aspects when it comes to return on equity. While the figure may help determine the overall profitability of the company, there are other factors. For example, those companies with a high overhead may have a lower return on equity, but can still be very profitable. Companies with lower overhead may have a higher return on equity but still may not be the best investments. Therefore, all tools should be taken into account when the decision comes to buying stock.

No matter what return on equity formula is used, or what the motivation may be for determining it, investors should always remember there is no sure bet. The best bet for most new investors is to rely on the advice of a financial adviser. While there may be more expenses involved, the overall results tend to be much better.

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