Return on equity (ROE)
Return on equity (ROE) is defined as the ratio of net income returned by a firm during a specified period (normally an accounting year) to its owners or stockholders. ROE is a simple measure of the past and current profitability of equity investments in the firm.
It is calculated by dividing the net profit by the weighted average of equity. ROE may also be calculated by dividing net income by shareholders' equity. If there was a reduction in the equity or an increase in paid-up equity anytime during a financial year, then the weighted average must be calculated. If there is no change in equity during the entire period, equity of the first day of the year is used in the calculation.
ROE measures a firm's capability and efficiency in generating adequate surplus revenues after meeting expenditures and liabilities. Consistent and growing ROE over a period of time generally enhances a firm's value.
Negative Return on Equity
When a business's return on equity is negative, it means its shareholders are losing, rather than gaining, value. This is usually a very bad sign for investors and managers try to avoid a negative return as aggressively as possible. Most investors avoid placing their money in a company that fails to consistently deliver positive returns, but investors may overlook a negative return for a single tough year if they believe the company is well-positioned for long-term growth.
Companies that report losses are more difficult to value than those that report consistent profits. Any metric that uses net income is basically nullified as an input when a company reports negative profits. Return on equity (ROE) is one such metric.