Return on Equity (ROE) is a measure of a company’s profitability. It is calculated as the net income of a company divided by the shareholders’ equity in the company. As with everything that can be defined subjectively, you should know how a reported ROE is being calculated.

Most analysts would exclude dividends paid to preferred shareholders from net income, and shareholders’ equity is usually calculated as an average over some given period. ROE is closely related to Return on Assets (ROA); it is calculated as ROA times the company’s leverage (total assets divided by shareholders’ equity).

ROE is one way to gauge the performance of a company’s management—with higher ROE generally equating to better management—especially when comparing companies in the same industry. However, ROE can be skewed if a company has very little shareholders’ equity but is still profitable (generating a very high ROE that likely isn’t sustainable) just as a company with massive shareholders’ equity can generate a very low ROE if it has a bad quarter.

Investors need to look at numbers like ROE and ROA and then look at the underlying numbers to see how the ratios were derived. Reading a company’s annual report and visiting Web sites like www.Morningstar.com are invaluable in assessing what a company’s valuation ratios mean. For example, a company’s shareholders’ equity may include significant amounts of goodwill that aren’t generating profits, which will reduce ROE.