One way to measure a company’s efficiency is to calculate its Return on Equity or ROE. As you know, equity is something the owners have invested into the company on one hand in the form of share capital and on the other hand as retained earnings meaning the profit that has not been distributed, but instead has been invested into machinery, equipment and so on.

ROE is an indicator of how profitable the company is in relation to total capital invested by its shareholders. Consequently, ROE is calculated as follows: annual earnings (net profit before dividends paid out) are divided by shareholders equity (excluding preference shares). The end result is displayed in percentage thus showing how profitable the equity of a company is.

When measuring ROE, the higher the number the better since it means the company is earning more money on less investments. For an example, we have company A and B. Company A earned 100,000 with 3,000,000 worth of equity thus making the ROE 3%. Company B has the same amount of equity, but made 1,000,000 of profit resulting in ROE of 33%. Looking at our example, it is obvious that the company B is better managed since it converts its investments into bigger profit than company A.

As always, when comparing ratios and on this case ROE of different companies, they may differ significantly due to industry sectors the companies are in. To get the most objective and fair comparison, it is best to look at ROEs within same business sector or of the same company but different periods.