Return on equity or ROE can be calculated as,
ROE indicates return on investment that the investor is getting from company's profits. Simply put, ROE is stakeholder's return on investment.
For example, stock ABC reported $200 million in profits with 700 million in shareholder's equity at the beginning of financial year, and 900 million shareholder's equity by the end of financial year. It's ROE will be 25 per cent.
Another example, stock XYZ has $800 million shareholder's equity in the beginning of financial year. It bought new equipment worth $300 million as it's investment and make $80 million in profits.
At the same time, it invested the balance amount (another $500 million) in fixed deposit and earn another $20 million. By end of financial year, it gain $100 million in profits with total of $900 million in shareholder's equity. It's ROE will be 11.7 per cent.
In the following year, company XYZ face stiff competition from China that force them to stop business operation for a while. It's management decided to reinvest $900 million in fixed deposit and earned $35 million as interest. It's ROE will be 3.8 per cent.
From above examples, you can easily notice that though the company is making money from shareholder's equity, ROE for stock XYZ was substantially reduced from 11.7 per cent to only 3.8 per cent.
If the return is just like you invest in fixed deposit yourself, what for invest in them?I don't like taking EXTRA risks with no EXTRA return.
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