It is the income generated per unit of equity invested, i.e. how much returns shareholders/investors are getting on the money invested by them in the company. Please note that not all returns will be credited to the investor’s account. The company might decide to return only some amount as dividend and retain the rest for future investment purpose. However since all profits generated by the company, technically belong to the investors we use the same for return calculation.
ROE = PAT (income statement) / Total shareholder’s equity (balance sheet)
It is usually expressed as a percentage. In case of ABC Inc, it would be 24% (ROE = 12000/50000 = 0.24)
Let’s consider an example to understand how the ratio can be used by individual investors. Suppose you have Rs 5000 and are contemplating whether to invest in ABC Inc or a bank fixed deposit. Bank is offering 10% returns for a one year fixed deposit. However you are aware that ABC Inc. generated 24% returns last year. If you believe that ABC Inc. will continue to perform well and be able to sustain its profitability, then the company will probably generate 24% returns next year as well. Hence it would make sense to invest in ABC Inc. compared to bank fixed deposit.
One argument against investing in ABC Inc. is that past performance doesn’t guarantee any future performance and that the company might not generate high returns next year. But suppose ABC Inc. has continuously generated ROE of 24% over the previous 5 years, then there is a good chance that company might do this in the future as well. One should always look at the ROE history of a company to understand how much returns can be expected in the future. ROE also helps in comparing two different companies. However please make sure that only apples are compared to apples, i.e. similar companies from same sectors should be compared to each other.