Before investing in a stock in the stock market, we have to look and test many parameters. One of these parameters is ROE. ROE helps us in whether to invest in a company or not.
In this article on stock market investing, today we will know what is ROE, how ROE is calculated and how to use ROE while choosing a stock.
Table of Contents
What is ROE
ROE means Return on Equity. ROE is a profitability ratio that tells us how much profit a company is making on the equity of its shareholders.
In other words, ROE is a financial ratio that measures the ability of a company to generate profit on the investment of its shareholders. Thus, Return on Equity tells us the profit on the investment of the company as a percentage.
How ROE is Calculated (ROE Calculation)
ROE is calculated as a percentage of the company’s net income or PAT (Profit after Tax) by dividing the shareholder’s equity.
ROE = Net Income / Total Equity
| ROE Calculation Example |
ABC Ltd. |
XYZ Ltd. |
| EBIT (Earnings before interest & taxes) | 10,000 | 12,000 |
| Interest | 2,000 | 1,000 |
| Profit before Tax (PBT) | 8,000 | 11,000 |
| Tax (30%) | 2,400 | 3,300 |
| Profit after Tax (PAT) | 5,600 | 7,700 |
| Shareholders Capital | 12,000 | 18,000 |
| Reserves | 5,000 | 7,000 |
| Preference Shares | 3,000 | |
| Net worth (Sh. Equity) | 20,000 | 25,000 |
| (5,600 ÷ 20,000) × 100 | (7,700 ÷ 25,000) × 100 | |
| ROE | 28% | 30.8% |
Here, net income is calculated for common shareholder before paying the dividend and for preference shareholder after paying the dividend.
Net Income
Net income is the annual turnover of a company after deducting all expenses such as operating cost, interest, taxes etc. Net income is also called profit after tax (PAT). You will easily find this in the income statement of any company.
Share holder equity
Shareholder equity is the money that is invested in the company by the owners of the company. It remains after deducting the value of all the assets from all the liabilities of the company. This means that after settling the liabilities and assets, the shareholder equity remains.
You can also view this directly on the liability side of the balance sheet which includes share capital and reserves.
Benefits of ROE
ROE helps you to decide whether to choose the stock of a company or not.
1. Helpful in estimating the growth rate
Return on Equity can be used to find out the growth of a company effectively. This ratio helps you to find out the stock and dividend growth of any company.
2. Assessing the Sustainability of Growth
Using ROE, you can measure the sustainability of your company’s growth. This is especially useful when you choose a stock that is more risky in market volatility.
If you look at the current year’s ROE of a company which is a good ROE. This ROE does not give the overall position of that company. But by looking at the ROE of the company for the last few years, you get an idea whether the company is able to maintain its good ROE or not.
3. Comparison with rival companies
It is not considered fair to compare a company with a company in another sector. But using ROE, investors can compare the financial performance of a company to peers in the same industry.
By comparing with peers, we get to know that the ROE of our company is less or more than the industry.
Using ROE to Find Problems
Sometimes an ROE that is less than the ROE of another company but still can be a good ROE. Because high ROE can also be due to small equities which indicates too much risk. But when this high ROE is due to its high profit then it is considered good.
How much ROE is considered good?
However, no standard of ROE has been set. It can be different for all companies. Generally, a return on equity between 15 to 20% is considered good. Higher ROE can also be better provided the figures are not misleading. Companies with less than 10% ROE can be classified as poor ROE company.
ROE Interpretation
If a company has a high ROE, then it tells us that the management of the company is more efficient. They are making good returns to their investors from managed investments.
If the ROE has been rising steadily over the years, it indicates that the management is looking forward to good returns for the investors. But a low ROE tells us that the company is not being operated properly. The management may be investing its income in an asset that is unproductive.
Limitations of ROE
By the way, ROE is considered one of the most important financial ratios to test any company. But even then there are some limitations of ROE.
We cannot judge any loss making company by ROE. Thus companies with negative ROE cannot be compared with companies in the same sector that have positive ROE.
Apart from this, the movement of economy can be the reason for change in ROE of a company. If the economy conditions are good then the ROE can be good whereas in slow economy the ROE can be low. This can make it very difficult to judge a company by ROE.
Factors Affecting ROE
1. Depreciation- Due to high depreciation, the net income decreases, which reduces the return on equity, which does not reflect the true ROE of the company.
2. Investment’s growth rate- Such companies which are fast growing companies require more capital due to which the ROE is less visible.
3. Share Buyback- If a company buys back its shares, then the outstanding shares of the company are reduced, which increases the ROE.
4. Capitalization Policy- Even if low market capitalization is mentioned in the books of the company, then the ROE can be low.
Are companies with high ROE good?
Many times we make a mistake by looking at the profits of two companies in the same sector. Are high profit companies really good?
Let us see it with an example:
| Ram Ltd. | Shaym Ltd. | |
| Profit before Tax (PBT) | 60,000 | 90,000 |
| Tax (30%) | 18,000 | 27,000 |
| Profit after Tax (PAT) | 42,000 | 63,000 |
| Shareholders Capital | 1,00,000 | 1,50,000 |
| Reserves | 50,000 | 2,00,000 |
| Net worth (Sh. Equity) | 1,50,000 | 3,50,000 |
| (42,000 ÷ 1,50,000) × 100 | (63,000 ÷ 3,50,000) × 100 | |
| ROE | 28% | 18% |
In this example you have seen that Shyam Ltd. Benefits of Ram Ltd. But the ROE is more than that of Ram Limited. Ram Ltd. is giving high return on capital employed. Therefore, here Ram Limited will be considered a good company according to investment.
Relationship of Debt and ROE
Debt increases the leverage factor in any company so that the ROE received is miss-leading.
Example:
| Debt Ltd. | No Debt Ltd. | |
| EBIT (Earnings before interest & taxes) | 200 | 200 |
| Interest (10%) | 50 | – |
| Profit before Tax (PBT) | 150 | 200 |
| Tax (NIL) | – | – |
| Profit after Tax (PAT) | 150 | 200 |
| Shareholders Capital | 500 | 1,000 |
| Debt | 500 | – |
| Reserves | – | 200 |
| Net worth (Sh. Equity) | 1,000 | 1,200 |
| (150 ÷ 500) × 100 | (200 ÷ 1,200) × 100 | |
| ROE | 30% | 16.67% |
In this example you have seen that due to the debt in the company, the cost of capital is charged at 500, thereby increasing the ROE to 30%.
This means that 10% interest on debt is giving 30% return on equity. But in reality, only 100 return on equity is being generated, then after deducting debt of 50, the net profit will be 50 only. Accordingly, the ROE will be –
(50 / 500) x 100 = 10%
Thus many companies increase their return on equity by taking debt. Hence, ROE is less important in a debt company. You should check RoCE in a debt company.
Key Takeaways
- To judge the ROE of a company, one has to look at the ROE of the peers of that industry or company.
- Continued fall in ROE does not bode well for the company.
- An increase in ROE is considered good both from the point of view of the company and the investor.
Where to get ROE information
You can get Return on Equity information from moneycontrol, finology, tickertape etc.
Conclusion (What is ROE)
To measure the financial efficiency of a company, it is very important to look at ROE. Therefore, before investing in the stock of any company, definitely check the ROE of the last few years.
You should avoid investing in companies with negative ROE. It is also not that one has to blindly believe in a high ROE. You should find out the reasons for high ROE. A good ROE also reflects the efficiency of the management. That’s why it is considered important to focus on ROE while choosing a stock.
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