How is return on equity (ROE) calculated?

Return on equity (ROE) is a financial metric that measures the profitability of a company in relation to the equity held by its shareholders. It is calculated by taking the net income of the company, which reflects the total profit after expenses, taxes, and costs have been deducted, and dividing it by the average shareholder's equity for a specific period.

Calculating ROE using average shareholder's equity provides a more accurate picture of how effectively a company is using the capital invested by shareholders to generate profits. This approach smooths out any variations in equity that might occur due to seasonal changes or one-time events, giving investors a clearer understanding of the company's operational performance and profitability trends over time.

The emphasis on net income ensures that the performance measure considers actual profits that are attributable to shareholders, making it a relevant indicator for evaluating the efficiency of a company in generating profits from its equity. Hence, the focus on average shareholder's equity is crucial for capturing the investment made by shareholders throughout the period.

In contrast, the other options do not accurately reflect the relationship between net income and shareholder equity. These alternatives either involve different denominators (like total revenue, total assets, or liabilities) that do not align with the definition of return on equity as a measure of profitability