Basics of Equity and Return On Equity

The best way to find the most suitable stock for investments in the long run often involves finding the companies capable of consistently generating an appreciable return on Equity over many decades. Here you might be wondering what Equity and Return on Equity are. 

In this blog, we will share a quick overview of Equity and return on Equity with some suitable examples and simple ways of calculating them. So, without any more delay, let’s get straight into it.

What is Equity?

Equity is the value of an asset after removing or subtracting the value of any liabilities on the asset. It is commonly used to describe the value of an asset that can help purchase a new one. These shares are typically traded on a stock exchange.

At the business level, Equity is the value of a corporation’s stock. It helps determine the financial strength of the business’s owner or shareholders to continue funding its operations. In other words, Equity is the amount of money that a company’s shareholders may receive if all of their official assets are liquidated, and all of the company’s debt is paid off in the case of liquidation.

What are the potential benefits of equity investments?

The main advantage of an equity investment is the possibility of increasing the value of the principal amount invested. Equity comes in the form of capital gains and dividends. This type of fund offers investors a diverse investment option typically for a minimum initial investment amount.

What is Return on Equity?

One of the most effective profitability metrics for any investor is a company’s return on Equity (ROE). Return on Equity tells how much after-tax income a company earned in the financial year compared to the total amount of shareholder equity available on the balance sheet.

ROE offers a clear visibility on the financial ratios and profitability metrics. Alternatively, ROE can also be determined by dividing its dividend growth rate by earnings retention rate (1 – dividend payout ratio). Let us discuss the calculation in detail.

Return on Equity Calculation

The formula.

Return on Equity = Net Income ÷ Average Common Stockholder Equity for the Period

To calculate the shareholder equity, subtract total assets with total liabilities. 

To explain, shareholder equity is a process that represents the assets created by the retained earnings of the business and the paid-in capital of the owners. It is required to calculate the correct return on Equity.

A sustainable and increasing ROE over time can mean a company can generate shareholder value because it knows how to reinvest its earnings wisely to increase productivity and profits. In contrast, a declining ROE can mean that management makes poor decisions on reinvesting capital in unproductive assets.

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