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What is return on equity?
Let's say an investor owns a certain amount of stock in a company. The investor's Return on Equity (ROE) is the rate of return they receive on their shares. This is calculated as a ratio and can be used to measure the ability of a company to generate returns. Firms with higher ROEs are generally preferred by investors who may use it to compare stocks within the same sector. This is because profit levels can vary across different sectors.
ROE = Net Income/Shareholder's Equity
As an example, let us assume that a firm generates a profit of $100,000 and has 1000 shares held by stockholders with a valuation of $50 per share. The firm then has to pay interest worth $10,000 to its lenders, which is deducted from profits to get net income.
ROE = (100,000 – 10,000) / (1,000*50) = 1.8
This means that investors generated $1.8 for every dollar invested.