Return on Equity (ROE) = PAT/ Net-worth
In simpler terms, ROE is calculated by dividing a company’s net income by book value or its shareholder's equity. ROE defines the company’s financial success as it indicates whether the company is making profits without infusing new equity capital. Accordingly, investors will be able to identify the financial soundness, the merit of the company, comparison with the peer group and many more aspects of the company.
As a shareholder, one must always compare the ROE of the company for various periods to ascertain the financial growth of the company and accordingly decide between staying or taking an exit. It is an excellent tool to compare a company’s performance with other peer companies. ROE signifies how well a company uses its shareholder's money. A high ROE also tells you that the company has enough capital to make payments to the shareholders.
ROE helps stakeholders understand the sustainable growth rates of the company. Moreover, a high ROE is an indicator that the company has made optimum use of the capital and a part of the profits which are generated by the company can be received as Dividends. A higher ROE signifies that the company’s management uses investment financing to grow their business more efficiently and in turn will provide a better return to its investors and vice-versa.
Investors uses the ROE formula to understand the competitive advantage related to the long-term profits of the company and how long the company can reinvest gains to keep the cash flow stable and upwards. The ratio essentially helps in ascertaining the return that the shareholders of the company will receive on their shareholdings.
E.g.- A company ABC has earned a profit worth Rs.31.5 cr and has a net worth Rs 128 cr In this case, ROE shall be as under:-
ROE = PAT/ Net-worth
Net-worth = Equity Capital + Reserves & Surplus
ROE = 31.5/ 128 = 24.61%.
Thus, a higher ROE suggests greater profits generated by the company using the existing resources and effective utilization of capital assets.
An effective indicator of how the company utilizes its funds, ROE measures the company’s capacity and ability to generate profits from its existing shareholder's investments.
ROE provides a direct measure for equity investors to understand the earnings that the company will generate for them in the future. It is also to be understood that a lower or negative ROE does not always signify a bad thing. Maybe, the company is improving its business through restructuring by investing its existing funds.
Return on Equity is generally used for comparing the performance of peer group companies and trying to analyze the company management ability to generate wealth from the equity available with the company. By analyzing this ratio, investors can choose the most viable investment option to reap profits in the long run.
One must understand that no single ratio can define the company’s financial growth or performance. Thus, even ROE speaks half the truth. The ratio gets bigger whenever the shareholder’s equity value, i.e. the denominator keeps going down.
Shareholders must also keep that the ratio is a little manipulative. The ratio can be influenced by the owners of the company. E.g. -When a company uses debt financing, the ROE may show improved growth but the company’s income may be stable. So, always remember that the ROE does not talk about the company’s long-term and short-term debt and thus some aspects of the company will always remain hidden while you only keep ROE in mind.
Similarly, excessive debt and lower equity share capital may make the ROE look higher than competitors but one must also study the Debt to Equity Ratio simultaneously to trade better in the online share market.
ROE also helps in assessing the company’s sustainability in terms of growth and the ratio helps investors understand which stocks are more vulnerable to financial instabilities and market movements.
Other metrics like Earnings per share (EPS), Price to Book (P/B), Price To Earnings (P/E), Book Value, Dividend Yield, and Dividend Payout Ratio must be studied along with Return on Equity (ROE) to trade intelligently on the share trading platform.