What is Return on Equity?

Prior to investing in a company’s equity shares, it is prudent to exercise due diligence by examining the company’s profitability within its respective market. Various financial metrics are available to aid in assessing a company’s profitability. This article will discuss one such financial metric, Return on Equity (ROE), which provides valuable insights into a company’s profitability and serves as a useful tool for evaluating its financial performance. Let us understand return on equity meaning, its interpretation and its formula.

About Return on Equity

Return on Equity (ROE) is the measure of how efficient a company is at generating profits. It can be described as the company’s net profit relative to its total shareholder equity, or the amount of money made for every rupee invested by shareholders. ROE is expressed as a percentage. You can use ROE to determine a stock growth rate and its dividend growth rate as well.

Calculating Return on Equity

Calculating ROE is simple and hassle-free. It is calculated by dividing the company’s net income by the equity of the shareholders. The Return on Equity formula can be expressed as follows:

ROE = Net income / Equity of the shareholders

Where,

• Net income – It is the company’s total income after deducting costs of goods, interest payments, taxes, and general expenses. It is also known as net profit. It is a key indicator of the company’s profitability.
• Equity of the shareholders – It is the total amount of the company’s capital that’s obtained from shareholders. In simple terms, it is the total amount of money invested by the shareholders in a company. It is mentioned in the company’s balance statement.

Here’s a quick example to explain the Return on Equity calculation better. Suppose you wish to calculate ‘Company A’ ROE. It has a net income of Rs 10,00,000, and shareholder’s equity of Rs 30,00,000. By substituting these values in the ROE formula, the following equation is derived.

Return on Equity = 10,00,000/50,00,000 = 0.20 X 100 = 20%

Interpreting Return on Equity

Naturally, a higher ROE is seen positively, as it indicates the company is efficient at generating profits. The ROE of a company needs to be compared with the ROE of its peers. The ROE of companies in a particular sector can be different from that of another sector. The target ROE should be equal to or just above the average for the company’s sector.

A constantly rising ROE over time can indicate that the company is efficiently generating value for its shareholders. It means that the company is effectively reinvesting its earnings which is resulting in increased profits.

However, falling ROE can imply inefficiency in generating value for shareholders due to poor decisions of management on reinvesting capital in unproductive assets.

However, a higher ROE doesn’t need to be always positive, it could be seen as a negative as well. For instance, declining equity investment can show high ROE. When the equity investment in a company falls, the returns will increase. However, this does not show higher profitability.

For instance, let’s consider ‘Company A’ had a net income worth Rs 10,00,000, with a shareholder’s equity accounting for a total of Rs 40,00,000 for the financial year 2021-22. Given, this its ROE would be 25%.

In the financial year 2022-23, the company had the same net income i.e., Rs 10,00,000. However, its shareholder’s equity accounted for a total of Rs 20,00,000 only. Given this, its ROE would be 50%. Considering the ROE, you may feel moved to invest in the company. But remember, shareholders drastically pulling out their equity investment is not a good sign.

Typically, it is always best to look for companies that have an equal or just a little higher Return on Equity than the industry average. This allows you to make a suitable investment and at the same time gain a competitive edge in the market.

Limitations of referring to Return on Equity

Like every other financial metric, ROE has its own set of limitations, of which you should be mindful. The following are the limitations of referring to ROE:

• A single metric cannot tell the entire story. ROE is just one of the many financial metrics you must refer to gauge a company’s profitability in the market. You must consider all aspects to make an informed decision.

• As mentioned before, a company’s ROE can increase if its equity investment declines. Hence, ROE can often mislead many investors.

• A company’s net income could possibly increase due to its efficient management of or availment of debt. If the company’s net income is increased due to the first reason it is seen positively. If the company’s net income is increased due to debt availment it is seen negatively. However, ROE does not help differentiate companies based on these two factors. Hence, making it difficult for investors to decide on which company to place bets on.

Bottom line

Return on Equity meaning is simple and straightforward. It is a key financial metric that provides valuable insights into a company’s profitability and financial performance. ROE serves as a useful tool for investors and analysts to evaluate a company’s financial health and compare it with industry peers.

However, it is important to note that ROE alone cannot provide a comprehensive picture of a company’s financial position, and other financial metrics should be considered in conjunction with ROE. Understanding ROE and its limitations can help investors make informed investment decisions and assess the long-term profitability of a company.

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