Return on Equity (ROE) A Key Indicator for Investors

As Ravi deepened his understanding of profitability ratios, he realised that each metric brought him closer to grasping effective company operations. He assessed core profitability through gross profit margin and operational efficiency with operating profit margin. Now, he was ready to explore a critical metric that investors worldwide closely watch—Return on Equity (ROE). This would help Ravi understand how well a company utilises its resources to generate returns for its shareholders.

What is Return on Equity (ROE)?

Return on equity (ROE) measures a company’s financial performance, highlighting how efficiently it generates profits from shareholders' equity. Essentially, ROE answers: "For every rupee invested by shareholders, how much profit does the company make?"

It is calculated using the formula:

ROE = (Net Income / Shareholder's Equity) * 100

Example: If a company has a net income of ₹50 lakh and shareholders' equity of ₹2 crore, its ROE would be:

ROE = (50,00,000 / 2,00,00,000) * 100 = 25%

This means for every ₹1 of equity invested, the company generates ₹0.25 in profit, indicating how effectively it uses its equity base.

How ROE Works

ROE is expressed as a percentage and indicates how efficiently a company uses its equity financing to generate profit. A higher ROE generally suggests that management is more efficient at creating profit from net assets, which may indicate a strong competitive position and effective management.

However, whether an ROE is "good" or "bad" can vary by industry. For instance, utility companies might have ROEs around 10% or less due to high assets and debt, while tech firms may exceed 18% because of lower asset intensity. Comparing ROE against industry peers is vital to understanding whether a company outperforms others in the same sector.

Using ROE to evaluate Stock Performance

Investors often use ROE to estimate a company’s growth rate. This involves multiplying ROE by the retention ratio, the percentage of net income retained for growth rather than distributed as dividends.

Example: If a company has an ROE of 15% and retains 70% of its net income, its estimated sustainable growth rate (SGR) would be:

SGR = ROE * Retention Ratio = 15% * 70% = 10.5%

This growth rate indicates how quickly the company can expand without additional borrowing or issuing shares.

Risks and Limitations of ROE

ROE provides valuable insights but has limitations:

• High ROE as a Warning Sign: An extremely high ROE can be misleading if a company has low equity due to prior losses or excessive debt, inflating the ROE.

• Inconsistent Profits: A company returning to profitability after losses may have a misleadingly high ROE due to low equity.

• Not Comparable Across Industries: ROE should only be compared among companies within the same industry, as different sectors have varying capital requirements.

Conclusion

With a solid understanding of Return on Equity (ROE), Ravi recognised its importance in evaluating a company's ability to generate returns from shareholders' investments. ROE provides insights into how well management uses equity to create profits, crucial for informed investment decisions.

You are now better equipped to evaluate companies from both operational and financial efficiency perspectives. The next chapter will introduce Return on Assets (ROA), another key metric for assessing how effectively companies use their assets to generate profit.