Understand the meaning of Return on Equity (ROE)

Stock investors often rely on financial ratios to assess the profitability and efficiency of public companies. When the company performs well, investors can enjoy high returns. Return on Equity (ROE) is one such financial ratio used by the investors during fundamental analysis of a company. Let us discuss the importance and uses of this ratio for investors.

What is Return on Equity?

Return on Equity is a financial ratio that represents the performance of a company over a period. Public companies have many shareholders, from retail to institutional. These investors want to know how well their money is being used by the company. They get to know the same through this ratio. It explains the profit made by the company for every penny or rupee invested by the shareholders.

In simple terms, it is defined as the profit made by the company against shareholder equity. The total shareholder equity will include the initial investment made by stockholders. Total shareholder equity will also include the profit made on the initial investment through operations over time. ROE tells how well the company has used the original investment and retained earnings to make further profit.

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Importance of Return on Equity

ROE is a significant metric for both public companies and shareholders. Companies can understand the efficiency of their operations with the help of Return on Equity. On the other hand, investors also want to know how well the company is utilising the funding and retained earnings. A company with a low ROE might find it challenging to retain investors. Investors will understand the company’s inability to generate profits through ROE. For the same rationale, experienced and successful investors prefer companies with a good ROE. Different departments within a company can also use it to measure their efficiency. For instance, the management team can use it to determine the effectiveness of business operations and decisions.

Usage of ROE

Return on Equity helps investors make informed decisions. Investors can choose companies with above-average or high ROEs to build strong portfolios. The ratio also serves as a metric for competitive analysis. Investors can compare the ROEs of different public companies to make the right choice. Investors can track the ROEs of portfolio companies for performance assessment. Not to forget, companies themselves use the ratio to identify the efficiency of their operations. Companies can understand their profit-generating capability through the values derived from the calculation. Did you know lenders and credit rating agencies also use the ratio to make decisions? Lending institutions often hesitate to provide loans to companies with low ROEs.

Difference Between Rate of Return and Return on Equity

Beginners might get confused between the Rate of Return and Return on Equity. Even though both sound similar, they are used for different purposes. However, both are significant metrics for investment analysis. As discussed above, ROE is primarily used by investors to analyse the profit-making capability of a company. Public companies also rely on it to measure the effectiveness of their operations. On the other hand, the Rate of Return is used by investors to determine the gain/loss of different assets.

Rate of Return can be used to determine the gain or loss on any particular investment. To calculate the Rate of Return, you must know the initial investment value and the current/final value of the asset. You will then find the difference between the initial and final value of an investment. Upon dividing the obtained difference by the final value, you get to know the Rate of Return. Investors can use this metric to evaluate the gain or loss on stocks, bonds, mutual funds, and other assets in stock market

How to Calculate?

You can calculate the Return on Equity through this simple formula:

ROE = Net income/Shareholder’s equity

The net income isn’t the total revenue generated by a company. You must deduct the cost of goods, operational expenses, taxes, and other costs from the total revenue to find the net income. Similarly, the shareholder’s equity also consists of several factors. Besides the initial investment from stockholders, retained earnings are also counted as shareholder’s equity. Retained earnings are the profits generated from initial investment through company operations. You can calculate the shareholder’s equity through these two formulas:

• Shareholder’s Equity = Total Assets (tangible + intangible) – Total Liabilities

• Shareholder’s Equity = Initial Investment + Retained Earnings + Reserves (if any)

Public companies allow investors to access their balance sheets and other records. These records allow investors to find the information required to calculate the widely used financial ratios.

Ideal Values

Let us understand what is the ideal Return on Equity for investors:

Ideal ROE (in Percentage)

The ideal ROE will change according to the industry sector of the company. For example, the acceptable value range for financial institutions is between 10% to 15%. However, consumer goods companies are accepted to have it around 20% or 25%. For the same rationale, you must consider the industry sector before calculation.

• Is Good ROE Always Ideal?

ROE is an imperfect financial ratio, and it might not tell the complete picture at times. For instance, higher value might also be due to lower shareholder equity in a company. It means that not many investors have preferred to purchase the company’s stocks. Also, the ROE of a company might plummet due to various negative events and factors.

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Limitations of Return On Equity

As discussed earlier, the ratio has certain limitations, as it is an imperfect financial ratio. However, you can use Return on Equity together with other rations to get the complete picture. Let us understand the limitation with an example. Let us say a company has small shareholder equity and it makes a small profit. In such a case, the ROE will be positive, but the company hasn’t made significant profit. ROE can also grow when a company buys back its shares, which does not provide the complete picture to investors.

High ROE Stocks in India

There are several stocks in India with high ROE like:

FAQs

What is ROE in the stock market?

ROE is a financial ratio used by stock investors. It helps understand the efficiency and profitability of a company. It explains how well a company uses shareholder equity to make profits. Besides investors, companies also use it to measure the effectiveness of their operations.

What happens if ROE is negative?

A negative ROE indicates that the company has incurred a loss. It hasn’t made a profit on the shareholder equity through its operations. It is a bad sign for a company and indicates the depleting financial performance.

What causes high ROE?

When a company makes huge profits, its ROE increases. However, it can also increase due to other reasons. For instance, a decrease in shareholder equity.

What does a low ROE mean?

A low ROE signifies that the concerned company is not making ample profits. It reflects poor profitability, operations, and management decisions. Companies with below-average ROEs must reconsider their operations and business strategies. It means existing investors will lose their trust in the company. Also, the company might fail to attract new investors.

What is a good ROE?

Good or acceptable ROE fluctuates according to different sectors. For instance, financial firms must have a it between 10% to 15%. For manufacturing or consumer goods companies, the acceptable value is around 20%. Technology and software entities must have between 15% to 20%.