What is Return on Equity?

The media is rampant with successful investors that have become billionaires just by investing in the stock These stories start with them having a few thousand rupees which they turned over time into a fortune. The Indian stock market is a hugely opportunistic place, where you can garner immense wealth just by investing your capital and seeing it multiply with every passing day. However, along with such news, there are instances where a person has lost all of his capital in the stock market. With these contrasting reports, new investors looking to start investing become fearful and consider other investment avenues.

What sets apart the successful investors and the ones who lost their capital? It is the choice of stock. Choosing which stocks to invest in is the most important and complex thing in the process of investing and making profits. If your choice is based on assumption and herd mentality, you are in for losing your investments. However, if you choose stocks based on extensive research of affecting factors, you will always end up choosing a fundamentally strong company that can provide good returns on your investment.

But how to ensure that a company can offer you good returns in the future? What are the parameters used by successful investors to research various companies and choose the best one?

The answer lies in a stock market parameter called Return on Equity. Investors widely use return on equity to evaluate a stock and ensure that it has a high potential to multiply the investments.

What is Return on Equity?

Return on equity is one of the most vital parts of the process of Fundamental Analysis. It is the process of measuring the performance of a company to identify and understand the profitability of the company. Investors believe that through return on equity, they can understand how good a company is in generating profits and can buy its shares based on past performance, which they believe is likely to continue in the future. If you calculate the company’s return on equity, you can assume how much you can earn with the amount you have invested or thinking to invest in the company’s shares.

Sometimes people mistake return on equity and rate of return as identical. However, they are very different from each other. While return on equity measures how effectively a company is using an investors’ money to make profits, the rate of return only measures how much an investor has earned on the investment after a specific period.

How to calculate ROE?

Return on equity is always considered as a percentage figure and is calculated using the net income of a company and average shareholders’ equity.

• Net income of a company: The amount of income, taxes, and expenses generated by a company in a specific period.

• Average shareholder equity: It is the total of equity at the beginning and the end of a specific period divided by two.

Before you calculate the return on equity, you should ensure that the period for the net income and the average shareholder equity is the same.

Once you know the total income of a company and the average shareholder equity, you can use the following formula to calculate return on equity:

Return on Equity = Net Income of a company / Average shareholder equity

For example, suppose company ABC reported a net of Rs 10,00,000 and issued preferred dividends of Rs 15,000 during the year. The company also had 10,000, Rs 5 par outstanding common shares at the end of the year. In this case, the return on equity for the company will be:

Return on equity: Rs 10,00,000-Rs 15,000/(10,000x5)= 19.7%

So, the return on equity, in this case, is 19.7%.

What does return on equity tell us?

Looking at ROE alone is never a good thing, as ROE is a tricky indicator. For example, ROE may be low for a company if it has taken a recent loan for expansion. Even though the company can be well established to repay the loan and earn more profits through expansion, investors may not invest in the company if they consider the return on equity alone.

Investors who are experienced use a rule of thumb where they compare the return on equity of a particular company with the return on equity of that particular sector. For example, suppose a company belongs to the pharmaceutical sector and has a return on equity of 15%. In that case, you can compare it with the return on equity of the whole pharmaceutical sector to establish whether it can be a good investment.

ROE can also be used to evaluate a stock and predict the future price and growth rate of its dividends. Most investors use return on equity to compare a company’s stock with its peers in the sector. If they think that the return on equity is at par or better than the peer group, they decide to invest for the long term. For this estimation, you can multiply the company’s ROE with its retention ratio, which is the percentage of net income the company reinvests for expansion.

Benefits of return on equity

Here are the benefits of return on equity for any investor who is looking to invest and earn good returns:

• Investors can learn about a company’s financial performance and how it has managed its profitability over time.

• It is an effective tool to evaluate a company based on its competitors and ensure that it can manage sustainability and profitability in the coming years.

• Return on equity helps investors understand a stock’s price potential and gauge the future dividend growth rate.

• It is one of the most important tools used in the process of fundamental analysis. Without ROE, it becomes impossible to know if it is a good company to invest in.

• Return on equity can also be used to identify fundamental problems with a company such as excess debt, negative net income, and inconsistent profits.

Return on equity is a great tool to understand a company’s financials and how it can use its cash flow to ensure better profitability. Similarly, to investors, the stock price matters most; they give utmost priority to the company’s potential to increase its profits. With growing profits, the stock price increases, and the investors can ensure good returns on their investments.

If you want to understand further about return on equity and how you can calculate and use it to make informed investment decisions, you can consult the financial advisors at IIFL.