Return on Equity (ROE) = Net Income x Net revenue x Total Assets = Net Income
                                                 Net Revenue  Total Assets        Equity               Equity

Return on Equity (or ROE) measures a company’s return on total equity.  You may choose to use average equity in the denominator to adjust for fluctuations.

The ROE formula actually represents ROA times an “equity multiplier.”  This multiplier (the ratio of assets to equity) actually measures leverage.  A higher number indicates a greater proportion of debt financing.  Because of this, the effect of leverage is introduced into the ROE ratio.

The return on equity for Smith Heating and Cooling, Inc. is 4.67 or 467 percent.  While this return seems astronomical, the ROE for this company is an anomaly.  Take a look at the balance sheet.  The company is extremely highly leveraged; its net equity is only $3,000 versus total assets of $706,000.  In fact, the company had a deficit equity position prior to this year’s profit.  This is not a good situation.

Note also that equity is measured by book value, which may differ significantly from market value.