Return on Equity

Return on Equity compares profit with the equity invested. It shows how much a company generates from its owners' capital. A high return on equity is particularly attractive for investors.

It is calculated as net income divided by average equity for the period. Its defining feature is dependence on capital structure: replacing part of the equity with debt raises the ratio as long as the return on total capital exceeds the cost of debt, without anything changing in the operating business. Conversely, a high value does not automatically indicate operational strength but can equally rest on high leverage, which also raises risk.

Accounting distortions also matter: equity reduced by losses or distributions raises the ratio purely arithmetically, and companies with fixed assets carried at low historical values structurally show higher figures. For assessing operational quality, measures such as return on capital employed or return on invested capital are therefore better suited.

The DuPont decomposition shows where the return comes from: it is the product of net margin, asset turnover and the ratio of total assets to equity. This makes clear that a high return on equity can arise from a thin equity base alone. In leveraged buyouts this effect is the actual mechanism: on a purchase price of 100 million euros with 40 million euros of equity, an increase in value to 140 million euros with unchanged debt doubles the equity value, while enterprise value has risen by only 40 percent. For financial investors, the return on their invested equity is decisive. They assess investment performance primarily through cash flows and exit proceeds, using measures such as internal rate of return and money multiple rather than accounting return on equity alone.