Understanding Return on Equity of Companies in the Share Market

Introduction

Share market investment is not just about buying many stocks, waiting for the price to appreciate and then selling them off. It is much more nuanced. As an investor, you need to look at various metrics and ratios to analyse its profitability before investing in it. One such metric popularly used to analyse companies in the share market is the return on equity.

What is Return on Equity?

No one wants to invest in a company that does not generate profits. Return on equity is a profitability ratio that tells an investor how much they get on their shareholdings in a particular stock. It indicates whether a company is making enough profits with its current capital without having to infuse more. It can be thought of as a measure of the financial soundness of a company.

It is calculated as the net income or profits generated by a company divided by the total shareholder’sequity.

Return on Equity = Net Income /Shareholder’s Equity

Shareholder’sequity is the difference between the long-term assets and the long-term liabilities of a company.

Let’s understand this with an example. Say a company named ABC Ltd. Has generated revenues worth ₹300 crore and has made a net profit of ₹30 crore. Its total assets are₹850 crores, and it has outstanding long-term liabilities of ₹675 crore.

Now, its shareholder’sequity will be calculated as the difference between its assets and liabilities. In this case, that would be ₹175 crores.

ROE = Net profit/ Shareholder’s Equity

= ₹30 crore/ ₹175 crore = 0.1714 or 17.14%

Return on Equity Interpretation

You can compare the return on equity of a company in the share market with its past periods. A rising ROE is a positive indicator. It means that a company’s management efficiently utilises the money to expand the business and generate returns. A falling ROE means inefficient use of capital and, thereby, lower profitability for investors.

It may also be helpful to compare industry ROE to understand better the market the company is positioned within. Certain industry factors may cause a lower ROE in a particular period.

Benefits of Measuring Return on Equity

• Understanding the Growth Rate

Return on equity is an excellent measure to gauge profitability, and hence, a company’s growth potential.

• Sustainability

A constantly-growing ROE is a positive indicator, meaning that the company is sustainably increasing its profits for shareholders. This ratio can also be compared against the sustainable growth rate ratio to understand whether they are moving in tandem.

• Management evaluation

Following the ROE of a company over a while is also a fair indicator of how a company’s management is. An efficient managerial team will be capable of generating profits for shareholders. Comparing ROE over different management periods can be an excellent way to compare how different leaders have fared.

Limitations of the Ratio

While ROE is a financial metric to understand the way companies use their equity. But, it does have its limitations. For instance, large outstanding debts may reduce the ROE of a company, but the debt may be employed for new projects that would aid growth.

Higher depreciation of assets could lower a company’s profits and, therefore, significantly influence the final ROE ratio.

On the other hand, projects that have a more extended period may show an overstated ROE.

That is the reason why an investor must always look at other financial ratios in addition to ROE to understand a company’s full financial status. Some useful metrics to consider are earnings per share, return on assets, price to earnings ratio and dividend payout ratio, among others.

Conclusion

Return on equity is definitely a useful measure to estimate whether a company will be profitable or not. However, it needs to be studied alongside other metrics for a complete picture of a company’s financial health.

Disclaimer – ICICI Securities Ltd. ( I-Sec). Registered office of I-Sec is at ICICI Securities Ltd. – ICICI Venture House, Appasaheb Marathe Marg, Prabhadevi, Mumbai – 400 025, India, Tel No : 022 – 6807 7100. The contents herein above shall not be considered as an invitation or persuasion to trade or invest.  I-Sec and affiliates accept no liabilities for any loss or damage of any kind arising out of any actions taken in reliance thereon. The contents herein above are solely for informational purpose and may not be used or considered as an offer document or solicitation of offer to buy or sell or subscribe for securities or other financial instruments or any other product. Investments in securities market are subject to market risks, read all the related documents carefully before investing. The contents herein mentioned are solely for informational and educational purpose.