Return on equity (ROE): What is it?

Introduction 

“Best stocks with high ROE to add to your portfolio” – do you often hear this phrase and wonder what it means? ROE is one of the key ratios that gauge a firm’s profitability in relation to the equity owned by its shareholders.

Just like how a doctor uses various health indicators like blood pressure, heart rate, and cholesterol levels to assess a patient’s health, financial ratios are tools investors and analysts use to measure a company’s financial health. 

Financial ratios offer insights into a company’s operations, including liquidity, financial stability, profitability, etc. ROE is one of the key financial ratios used. 

Let’s delve deeper into what ROE is, how it is calculated and the significance of ROE in this article!

What is ROE in the stock market? 

Return on Equity (ROE) is a metric that evaluates a company’s financial performance. It measures a company’s profitability and the effectiveness with which it produces those profits. 

In simple terms, ROE is a gauge for evaluating how proficient a company is at generating earnings from the capital invested in it.

Here is how it works: Let’s suppose you invested some capital in a company’s shares. . The capital you’ve invested is your ‘equity’. The company then utilises this capital to operate its business and generate profit. 

Your Return on Equity (ROE) is how much profit the company made with the capital you invested in it. Therefore, if a company has a high ROE, it indicates that it is highly efficient at using the invested capital to generate profits and vice versa.

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What is the significance of ROE? 

Return on Equity (ROE) is a crucial financial indicator due to the following reasons:

1. Financial stability: ROE can reflect a company’s financial well-being. Firms with an ROE higher than their competitors may yield superior returns for their investors.

2. Efficiency: This metric assesses the effectiveness of a company in utilising its equity funding to generate income. An increased ROE implies that a firm is enhancing its profit-making ability without requiring substantial capital.

3. Management efficacy: ROE can also demonstrate how efficiently a company’s management is utilising shareholder funds. An upward trend in ROE indicates effective decision-making by management, while a downward trend may suggest less efficient use of equity capital.

4. Profitability: ROE gauges a firm’s efficiency with which it generates profits. So, if the ratio is higher, it means the firm is effective at converting its equity funding into profits.

5. Performance monitoring: A company’s ROE can be compared over various periods to monitor the performance of the company’s management.

6. Investment choices: Identifying companies with consistent and increasing ROE over the past five to seven years can aid in spotting potentially profitable stocks.

How to calculate return on equity? 

ROE formula = (Net Income / Shareholders’ Equity) x 100

Here, 

Net income is the total profit a company has made in a specific period after deducting all expenses. These expenses include operational costs, interest payments on any loans, taxes, and depreciation. This figure can be found at the end of a company’s income statement (profit and loss statement).

Shareholders’ equity is essentially the remaining interest in the company’s assets after all liabilities have been subtracted. Put simply, it is the sum that would be allocated to shareholders if every asset of the company were to be sold off or liquidated and all its debts settled.

Also read: What is CAGR and how to calculate? [ Explained]

Shareholders’ equity = Total Assets – Total Liabilities

Here is the return on equity example for better understanding. 

Below is the balance sheet and profit and loss statement of HUL (Hindustan Unilever Ltd) 

Here, the net income for FY 2022-23 is ₹9,962. 

Shareholder’s equity is = Total Assets – Total Liabilities 

= ₹71,825 – ₹21,604 = ₹50,221

ROE ratio formula = (Net Income / Shareholders’ Equity) x 100

= (9,962/50,221)*100 = 19.83%. 

How to use ROE?

ROE can be used in several ways to analyse a company’s performance and make investment decisions:

1. Compare companies: You can use ROE to compare the profitability of different firms in the same industry. A firm which has a higher ratio is generally considered more financially efficient than its peers.

2. Tracking performance over time: By comparing a company’s ROE from one period to the next, you can track changes in its financial efficiency and profitability. This can assist you in determining whether the company’s performance is on an upward trajectory or experiencing a decline over time.

Limitations of ROE 

Here are some potential drawbacks of the ROE metric:

1. Overlooking debt levels: The return on stockholders equity metric primarily concentrates on equity and net income, neglecting the impact of debt. A substantial debt load can amplify ROE while subjecting the company to financial hazards. 

2. Impact of accounting policies: The ROE calculation can be affected by the different accounting policies that companies adopt. Comparing the ROE ratio among companies employing diverse accounting methods may not offer a fair basis for comparison.

Also read: EBITDA explained: Definition, calculation, significance, and more 

Bottomline

To sum up, Return on Equity (ROE) is a multifaceted metric that delivers crucial insights into a company’s financial health. When used judiciously in conjunction with other financial indicators, it can guide investors and businesses in making enlightened decisions about investments, strategic planning, and expansion.