When investing in the stock market, an investor should learn about the different financial ratios used for the fundamental analysis of companies. Return on equity (ROE) is an essential parameter that helps potential investors analyse a company’s profitability. It indicates how well a company has utilised its shareholders’ money. One can calculate a company’s ROE by dividing the net income of the company by total shareholder equity and is denoted by percentage.
The following sections in this blog will cover more essential details about return on equity.
Why is ROE so important?
The meaning of return on equity is described as a financial ratio that calculates the net profits earned by a company as a percentage of the shareholders’ equity.
So, what does it mean when a company has a low ROE? It indicates that the company has not been able to make good use of the money invested by its shareholders. In other words, a low ROE implies that the company is unlikely to offer high returns to its investors.
While every stock market investor should know how to check, compare and analyse the ROEs of different companies, it should not be the only factor guiding one’s investment decisions. The management of a company can manually alter its ROE and it would prevent investors from making accurate analyses of a company’s financial condition.
How to calculate ROE?
The return on equity formula is as follows:
Return on equity = Net income/ equity of the shareholders
In this formula, ‘equity of shareholders’ stands for the average equity available for the business’s shareholders. It is defined as a company’s net worth that would be returned to its shareholders after the company liquidates itself and pays off its debt.
The company’s net income is simply available in the company's income statement. It is the earnings of a company before the latter has paid dividends to shareholders. Some financial analysts prefer checking the net income of the previous twelve months while measuring ROE.
There are some important factors that investors must remember regarding the ROE formula. One can estimate a company’s net income by subtracting its cost of goods sold (COGS), selling, general and administrative expenses (SG&A), amortisation, depreciation, taxes and interests from its sales revenue.
Investors should also note that net income is also called net earnings or net profit.
Why studying the ROE formula is significant?
Discussed below is the importance of the ROE formula:
- ROE depicts a company’s financial soundness, including the strength of its organisational framework.
- Investors can use this formula to analyse the financial growth of a company. It indicates whether a company has grown steadily over the years or not.
- While one cannot use ROE to determine the financial performance of companies in different sectors, one can still use it to compare the performance of companies in the same segment.
- Management professionals and investors use the return on equity formula to analyse whether there are financial discrepancies in a company’s balance sheet or not.
What do companies with high ROE indicate?
Here’s what a high ROE indicates for companies:
- Companies that have a high return on equity are well-equipped to make optimum use of shareholders’ money. It indicates to people that investing in the company would be a good option as it will continue to generate profits.
- Companies with a high ROE have expertise in retaining earnings and retained earnings are a good source of capital. Investors should check a company’s annual retained earnings and ROE for a year. If they witness that a company has generated profits and has a good ROE, it can successfully retain earnings.
- With a high ROE, a company has a significant advantage over its peers because it can better protect its long-term profits and enjoy a substantial market share.
How to use ROE in three ways?
- Investors can use ROE to estimate the sustainable growth rate and dividend yields of a company.
- As mentioned, a high ROE tells investors that a company is financially strong.
- People can also use the DuPont formula to analyse the factors resulting in high/ low ROE. The formula is as follows:
ROE (Return on equity) = (Net income/revenue from sales) x (sales revenue/total assets) x (total assets/shareholders’ equity)
Can the ROE of a company be in the negative values?
Yes, a company can have a negative ROE. Such companies yield zero returns. A negative ROE can be a result of the company having negative shareholder equity because its liabilities currently exceed its assets at a particular time.
Investors should remember that it isn’t a good idea to disregard a company with a negative ROE. While a return on equity is a suitable financial parameter to understand a company’s financial performance, investors should not be over-reliant on it.
It is an effective tool to identify industry/ market leaders, but one should also consider other aspects such as its PE ratio, debt-to-equity ratio, operating profit margin, etc.
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