Investing in stocks is not easy, especially when there are thousands of companies you can invest in the same domain. And it is a shared experience after, being unable to decide where to invest, we all have one thing to say: “investing is not my thing!” But thanks to online information and fundamental analysis indicators, you can quickly narrow down your options.
These indicators help you examine the overall financial health of the company. So investors can make informed investing decisions. Today we will discuss one of the most helpful fundamental parameters that investors should check while investing in stocks, Return on Equity (ROE).
ROE acts as a performance indicator for investors, helping them differentiate between companies. Now, let’s dive into understanding Return on Equity and how to use it.
What is Return on Equity?
Return on equity (ROE) is a financial ratio that measures a company’s profitability in relation to shareholders’ equity. It gives investors an idea of how much profit a company generates with shareholders’ money. With the ROE of a company, you can calculate the company’s net income.
How is ROE calculated?
You can calculate the ROE of a company with a simple formula: net income/ total shareholder’s equity. Net income is the overall profit that a company makes a year after deducting taxes and expenses, while shareholder’s equity refers to total assets minus liabilities. In simple words, it tells how much the stockholders or owners have invested in the company.
Now that you understand the basic formula of ROE, let’s answer the question below. While investing in a company, which company would you prefer to invest in based on its ROE? A company with a higher ROE or a company with a lower ROE?
Of course, a company with a higher Return on Equity is a preferable option. It is so because, with the higher ROE, the shareholders will receive higher profits.
Suppose there are two companies: A and B. The total net income made by both companies yearly is the same. However, the shareholder’s equity of company A is 100 crores, while that of company B is 1000 crores. Using the ROE formula, we get:
ROE of company A = 10/100 *100 = 10%
ROE of company B= 10/1000* 100= 1%
As an investor, you will choose to invest in company A because the profit will be distributed among 100 crores.
The Benefits of Return on Equity
Return on equity (ROE) is a financial ratio that measures a company’s profitability in relation to shareholders’ equity. It gives investors an idea of how much profit a company generates with shareholders’ money. With the ROE of a company, you can calculate the company’s net income.
It monitors companies’ performance
ROE is a helpful indicator for judging the financial health of a company. It measures how well a firm is using its resources to generate profits. A high return on equity means there has been ample opportunity to use what you’ve got. But a low ROE may suggest some areas that need improvement.
ROE is an important indicator for investors
Investors check ROE when making an investment decision. Higher ROEs are generally preferable to investors, as they indicate that the company is using its resources effectively. Conversely, a low ROE signifies market risks and financial instabilities.
Thus, while looking for companies with high ROEs, you may want to consider the following:
- Companies with competitive advantages that allow you to generate higher profits than their competitors.
- Companies with a low amount of debt will increase the ROE even if profits are relatively low.
- Companies that are growing continuously and have a high potential for growth in the future.
The Financial Leverage Effect on ROE
So far, from what we have discussed, you might have to come to one conclusion — invest in companies with a higher ROE. But it is not guaranteed that companies with higher ROEs will be profitable in the future. A company’s higher ROE could be the result of its high debts.
The use of debt can increase returns for shareholders, but it can also magnify losses. Therefore, investors need to understand how a company’s financial leverage affects its ROE.
When a company has a higher debt-to-equity ratio, it is said to be more leveraged.
The increased use of debt can lead to higher returns for shareholders, but it also carries more risk. If the company’s ROE falls, the loss to shareholders will be significant.
For example, a company with a debt-to-equity ratio of 2:1 and an ROE of 10% will have its return on equity as 20% if it had no debt. However, if the company’s ROE falls to 5%, then the company’s return on equity would fall to 10%.
The Limitations of Return on Equity
Despite its usefulness, ROE has a few limitations that investors should be aware of. One of the limitations is that ROE only looks at profitability concerning shareholders’ equity and not other financial measures such as total assets or total liabilities. This can lead to distorted conclusions about a company’s overall financial health.
Another limitation is that management can manipulate ROE. For example, a company could artificially increase its shareholders’ equity by issuing new shares or taking on debt. Thus, it would lead to a higher ROE even if its underlying profitability hadn’t changed.
Finally, ROE doesn’t take into account the time value of money. This means it doesn’t consider the fact that shareholders expect to receive a return on their investment not just today but also in the future.
The limitations of ROE make it a less-than-perfect measure for assessing company profitability. But by understanding ROE calculations and limitations, investors can make more informed investment decisions.
ROE and DuPont Analysis
Though calculating ROE is not difficult, there is another method you can use. It is called Dupont Decomposition. It is a financial analysis tool that breaks down Return on Equity (ROE) into two components: operating efficiency and financial leverage. This analysis can help investors better understand how each component contributes to a company’s overall ROE.
Mathematically, you can calculate ROE with DuPont Analysis with the below formula:
ROE= operating efficiency * financial leverage * (revenue/average assets)
The DuPont analysis can be used to spot trends in a company’s profitability and compare different companies’ profitability. It can also be used to assess a company’s financial health and identify potential problems.
The Bottom Line
The return on Equity (ROE) ratio is one of the top financial parameters that investors can rely on to check the overall financial health of a company. It can help you gauge how efficiently a company has been using its resources and whether it’s creating value for its shareholders.
While there are several ways to calculate ROE, the most common is net income divided by shareholders’ equity. This calculation factors how much profit a company makes, and the money shareholders put into it. However, it is noteworthy that ROE is just one metric to consider while making investment decisions. Factors such as the company’s debt levels, business model, and growth prospects are equally valuable while selecting a stock.
Leave a Reply