A company’s equity is the value of its net assets.
Return on equity is a company’s after-tax profit divided by its net assets.
The higher this number, the more efficiently the company is making use of its assets.
Companies that produce a high return on equity and reinvest the proceeds grow their annual profit faster than companies with a low return on equity. Investors, however, should be careful if companies are using high debt to produce an apparently high return on equity. (See examples below.)
Investments such as real estate can also be judged by their return on equity.
Example 1
You buy a rental property for $300,000 using $100,000 of your own capital and $200,000 of commercial mortgage.
After a year, you have collected $29,000 of rent. Your running costs were $3,000, you paid $12,000 interest on your mortgage and $3,000 in taxes.
Profit after tax = $11,000
Equity = $100,000
Return on equity = 11,000/100,000 = 11%
Example 2
As per Example 1, except you use $20,000 of your own capital and $280,000 of commercial mortgage. You pay $16,800 in interest and $2,000 in taxes. (Taxes fall as your interest bill rises and profit falls.)
Profit after tax = $7,200
Equity = $20,000
Return on equity = 7,200/280,000 = 25.7%
So, for the same business activity (rental property) taking on more debt leads to a much higher return on equity. Investors, therefore, should not use return on equity alone to compare businesses. They need to ensure the returns on equity are being achieved without using a high debt to equity ratio.