Return on equity (ROE) is a measure of the profitability of the stock company. It indicates how much profit a company has made in a specific time period corresponding to total shareholder equity recorded on the balance sheet.
The Return on Equity is a very important ratio, it helps the investor to find the return the shareholder earns for every unit of capital invested.
Return on equity(ROE) infographics by Kamlesh Rode
Image design Credits: www.figma.com
What is Return on equity (ROE)?
Suppose, there are two companies A limited and B limited industry. The A company is generating a profit of Rs.40 with Rs.100 investment whereas the B company is getting a profit of 300 with 1000 investments. So, you decide in which company you will invest.
Obviously, the B limited company is giving higher profits. However, the A company is more efficient as if you invest in 1000 you will end up with a profit of 400.
In simple terms, we can say that A company has a return on investment of 40% while the B company has 30% so A company will naturally become the preferred choice for investors.
Return on equity (ROE) is the profits or income you generate per year for each unit of your own money you’ve invested. It is a measure of profitability that calculates how many dollars of profit a company generates with each dollar of shareholders’ equity. The formula for ROE is:
ROE = Net Income/Shareholders’ Equity
ROE is sometimes called “return on net worth.
How it calculated (EXAMPLE)
Let’s assume Company XYZ generated $20 million in net income last year. If Company XYZ’s shareholder’s equity equaled $40 million last year, then using the ROE formula, we can calculate Company XYZ’s ROE as:
ROE = $20,000,000/$40,000,000 = 50%
This means that Company XYZ generated $0.50 of profit for every $1 of shareholders’ equity last year, giving the stock an ROE of 50%.
Importance of Return on equity (ROE)
1. High ROE means a company is efficiently generating profits on the money of shareholders
2. ROE is considered as a profitability ratio from the investor’s point of view.
3. ROE calculates how much money is made on the investment made by the investors, not the company.
4. ROE is a very prominent ratio used by investors for value investing.
5. A negative return on equity is the result of negative net income i.e losses.
6. A declining return on equity is because of a reduction in profit
7. An increasing return on equity indicates increasing profit.
Limitation of ROE
You must have observed that in calculating ROE, the denominator is shareholder’s funds. This means that if the value of the shareholder’s fund reduces, ROE will go up, even if profits are constant.
And because ROE uses equity as a denominator, even a small amount of net income with a smaller equity base could give a higher Return on Equity.
Promoters can often use this manipulative practice to influence the share price of the company. It is for this reason, trend analysis of 8-10 years becomes more useful to analyze the financial health of the company.
Also, to gain a better understanding of the financial health of the company, ROE should never be used in isolation. You should always consider using other ratios such as Return on Capital Employed, Return on Asset, and Debt-Equity Ratio along with ROE.
Conclusion
The Return on Equity is a very important ratio, it helps the investor to find the return the shareholder earns for every unit of capital invested. In other words, ROE shows the efficiency of the company in terms of generating profits for its shareholders.
Obviously, the higher the ROE, the better it is for the shareholders. In fact, this is one of the key ratios that help the investor identify the key financial value of the company.
Why Return on equity is important in fundamental analysis. Please read why fundamental analysis?
Frequently asked questions
Ans: Return on equity (ROE) is a measure of the profitability of the stock company. It indicates how much profit a company has made in a specific time period corresponding to total shareholder equity recorded on the balance sheet.
Ans: ROE = Net Income/Shareholders’ Equity
ROE is sometimes called “return on net worth.
Ans: High ROE means a company is efficiently generating profits on the money of shareholders. ROE is considered as a profitability ratio from the investor’s point of view.
Ans: The Return on Equity is a very important ratio, it helps the investor to find the return the shareholder earns for every unit of capital invested.
Answer: Calculating ROE, the denominator is shareholder’s funds. This means that if the value of the shareholder’s fund reduces, ROE will go up, even if profits are constant.
