Definition:

Return on Equity (ROE) is a financial performance metric that measures a company's ability to generate profits from its shareholders' equity. It indicates how effectively management is using a company’s assets to create profits.

Formula:

ROE = Net Income / Shareholders' Equity

How to use the metric:

ROE is used by investors to assess the efficiency with which a company is using its equity base to generate profits. A higher ROE indicates that the company is more effective at converting the investment into profits. It is often used to compare the financial performance of companies within the same industry.

Limitations:

ROE can be misleading if a company has a high level of debt, as it does not account for financial leverage. It can also be distorted by share buybacks, which reduce the equity base and artificially inflate the ROE. Additionally, ROE does not provide insights into the risk associated with the company's operations.

Applies to:

ROE is most applicable to industries with stable earnings and capital structures, such as consumer goods, utilities, and financial services, where it can effectively measure profitability relative to equity.

Doesn't apply to:

ROE may not be as useful in industries with high volatility or significant intangible assets, such as technology or startups, where earnings and equity can fluctuate widely, making ROE less reliable as a performance measure.

Summary:

Return on Equity (ROE) is a key financial metric used to evaluate a company's profitability relative to its equity. While it provides valuable insights into management efficiency and profitability, it has limitations, particularly in highly leveraged companies or industries with volatile earnings. It is most effective when used to compare companies within the same industry.