Return on Equity (ROE) is used to gauge a company’s profitability by looking at shareholder’s earnings from the investments of shareholders in the company. This ratio tells us how well a company is able to utilise the shareholders’ money. ROE can be calculated by dividing the net profits of a company by its net worth. If a company’s ROE is low, it indicates that the company is unable to efficiently use the capital invested by the shareholders.
A company that has ROE above 20% makes for a good investment. It indicates that investing in its stock could fetch lucrative long-term returns. ROE is closely connected to financial measures such as return on assets (ROA) and return on investment (ROI).
Why is ROE so important?
Return on equity is one of the effective ways of measuring a company’s profitability. Higher ROE means that the company is efficiently fetching earnings on new investment. Every stock market investor must learn how to check and compare ROEs of different companies before taking investment decisions. It’s also advisable to review ROE trends of the shortlisted companies.
However, solely relying on ROE for investment decisions is not advisable. This is because it is possible to artificially inflate ROE by management’s influence. For instance, when a company uses debt financing to reduce its share capital, the ROE increases even if the company’s income remains unchanged. A good thumb rule for investments is to aim for companies with ROE equal to or just above the average ROE of competitors.
How do you calculate Return on Equity (ROE)?
To identify potentially profitable investment opportunities, investors look at a company’s ROE. A higher ROE indicates that a company has a better capability to fetch profits from shareholders’ equity. So, how do you measure ROE?
ROE= Net Income/ shareholder’s equity
Using this simple formula, one can measure the returns from investing in a company. The net income of the company can be availed from its income statement. This denotes earnings before a company has paid out a dividend to its shareholders. Some analysts and investors may consider trailing income or the past twelve month’s income while measuring ROE. Some important points to note regarding ROE formula are:
- Company’s net income can be estimated by subtracting cost of goods sold (COGS), selling, general & administrative expenses (SG&A), amortisation, depreciation, interest, and taxes from sales revenue.
- Net income is sometimes mentioned either as net profit or net earnings.
- Another variable in the ROE formula is shareholder equity. This is the difference between a company’s assets and liabilities. It is the amount left for shareholders in case the company writes off all its liabilities using its assets.
Interpreting ROE results:
An investor uses ROE results to gauge how efficiently the company can use the investor’s money to generate additional revenues.
Investors mostly prefer companies with higher ROEs. ROE can also be used as a benchmark for picking stocks within the same industry sector. It is important to note that even within the same sector, ROE levels can significantly vary if some companies choose to give away dividends instead of retaining profits.
Let’s understand this with an example. Suppose a company ABC Ltd has about 1000 shares given to shareholders at Rs. 50 each. It has generated a profit of Rs. 1,00,000. The company then decides to issue a dividend worth Rs. 10,000 to all shareholders. The ROE will therefore be:
ROE = (1,00,000-10,000) / (1,000*50) = 1.8%
Thus, for every rupee of investment in ABC Ltd, investors can fetch Rs. 1.8. This is a high value investment in general terms, implying that the company may have recently started operations and could be in its high growth stage.
What does a high ROE mean?
Here’s how investors can use ROE as a measurement tool while identifying the investment worth of a company:
- Better capable to utilise shareholder’s money: Companies with a high ROE have a better capability to utilise shareholder’s money efficiently. If a company shows high ROE consistently over time, it can make for a good investment, since the profits may continue to grow as a result of efficient money management.
- Better earnings retention : Companies with high ROE can be proficient at earnings retention. Retained earnings make for a good capital source for any business. When a company is able to maintain its earnings and plough back the same in the form of working capital, it may not need additional debt and therefore can be free from any interest expenses. Investors must check the company’s annual retained earnings and its return on equity in the subsequent year. If a company generates profits and has an increasing ROE, it means successful profit generation from retained earnings.
- Added advantage over competition: Companies with high ROE often gain an advantage over their competitors since they can protect their long-term profits and enjoy dominance when it comes to market share. Such companies can continue to generate profits in the long term and reinvest the earnings for an ongoing cash flow.
Although helpful, ROE is not the only metric that should be used while gauging a company’s financial health and future prospects. To gain a 360-degree view of a company’s financial efficiency, ROE must be considered in conjunction with other financial factors, like return on assets and return on investment.
Some of the ratios that help in gauging a company’s financial health include the current ratio, quick ratio, return on assets, return on equity, and inventory turnover.
The four commonly used financial ratios include profitability ratios, liquidity ratios, solvency ratios, and valuation ratios or multiples.
A company’s balance sheet is a summary of its business assets (i.e., what the business owns) and liabilities (what the business owes). It shows how much money the company has left over if it sells all the assets and pays off all the debts at any point.
The method in which a company’s debt is considered is the primary difference between ROE and ROA. Without the presence of debt, shareholder equity and the total assets of the company are equal. However, if a company uses financial leverage, its ROE will be higher than its ROA. Therefore, ROA is a better measure for determining a company’s financial performance.
ROE figures are compared at different points in time. A declining ROE could be because the company is losing efficiency with regards to generating profits and thereby unable to increase shareholder value. Another reason for a declining ROE could be a heavy usage of debt for profit creation.