Stock markets are best analysed by a lot of ratios. A good understanding of ratios, numbers and figures can land you in good positions as far as your stock market investments are concerned.
One such important ratio is the Return On Equity – ROE. ROE is a profitability ratio that tells about the magnitude of a company’s profits on its shareholders’ equity.
ROE formula = Net Profit / Average Shareholder Equity
Net profit, or net income, is found on the income statement of a company. Shareholders equity is located on the balance sheet of a company. Average shareholders equity is calculated from the starting and ending figures of a particular financial year.
Example
A Company ABC has a net profit of Rs. 113 crore. Its average shareholders’ equity will be calculated by the average of the opening shareholders’ equity and closing shareholders equity.
Let’s say the opening shareholders’ equity is Rs. 838 crore, and closing is Rs. 398 crore. The average will be:
(Rs. 838 crore + Rs, 398 crore)/2 = Rs. 618 crore
Now, ROE will be Rs.113 crore / Rs. 618 crore = 0.183 or 18.3%
This means that Company ABC made profits of Rs 113 on average equity of Rs. 618 crore, which is equal to ~18.3% (ROE). Generally, the ROE of a good company is at least 15%.
Why is Return On Equity important?
Before investing in stocks that are on an upward trajectory – bullish stocks – it is crucial to analyse and do fundamental research on that company’s profitability. This is an essential step in investing, and getting a clear idea of the basics makes your investment strategy sound. Return on equity allows investors to understand the performance of the company.
This indicator is even helpful in comparing two stocks in the same sector. For example, when investors compare two real estate stocks, some of their benchmarks may reflect the industry. A thorough study of an indicator like ROE can give investors a clear picture of which stocks are best to invest.
Using the ROE metric
A good or lousy return on equity ratio is not a simple figure to arrive at. But there are some fundamental guidelines to keep in mind to create a generally profitable ROE round figure. An ROE value of less than 10% can be considered a bad result.
While it may pay off first, a high return on equity is not necessarily a good thing. This is because a high return on equity can occur due to several underlying issues, including outstanding debt or profit inconsistencies. Investors should always ensure that return on equity is combined with other metrics, such as debt and return on investment (ROI), to understand the firm’s financial condition.
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It is also essential to identify that the performance of "good" or "bad" stocks may vary by industry.
For example, the share returns in the utility sector are low, opposed to the efficiency of technology stocks which is generally high. Therefore, it may be helpful to compare metrics within an industry, but comparing metrics from different sectors can give a wrong impression of a company’s performance.
Return On Equity can help to identify problems
It makes sense to ask why an above-average or slightly higher ROI is better than a double, triple, or equivalent group average. Isn’t stock with a very high return on equity great for an investor?
In some cases, an extremely high ROE is good if net income is substantial in comparison to equity due to a company’s high-grade performance. However, a remarkably high ROE is often due to a smaller equity account than net earnings, symbolising risk.
Excessive Debt
One problem that can wrongly lead to a high return on equity is over-indebtedness. If a company borrows actively, it can increase its return on equity because its equity is equal to assets minus debt. The more debt a company acquires, the less equity it can have. A typical scenario is when a company borrows a considerable amount to buy back its shares. This may increase earnings per share (EPS) but will not affect accurate growth rates.
Inconsistent profits
The problem with a high return on equity is inconsistent profit returns. Imagine that a company has not made a profit for years. The annual loss on the balance sheet is presented as a “retained loss” in equity. This loss is damaging and reduces shareholders’ equity. Suppose the company made unexpected profits last year and becomes profitable. The denominator in the ROE calculation is now minimal after many years of losses, which makes its ROE misleadingly high.
In such cases, extremely high ROE levels should be considered a warning sign and be scrutinised before investing. In rare cases, a well-managed cash flow plan can lead to a negative return on equity, but this is the least likely outcome. However, you cannot evaluate a company with a negative return on equity compared to another stock with a positive ROE.
The debt parameter is crucial in calculating a company’s return on profits and should be carefully considered before investing. As part of your research, you should view a company’s current performance and gain an in-depth understanding of its ROE history that began at least 5-10 years ago. You can find it in the company’s annual report or a much more accessible format on the investing website Screener.In.
In the end, it is essential to remember that the basics of sound investing reside in intelligent investments into financially strong and profit-making companies – these are the shares that will give you gains in the stock market.
