Investor's Pick : Return on Equity

 

 

Warning: This article is filled with quirks which you never knew about a ratio which you've all heard of. Be it Novice or a Veteran investor, both use this metric extensively for picking quality stocks. Read at your own discretion!

 

To run a Business there are broadly two sources from where an entrepreneur can get funding money aka equity:

• The primary being the Shareholder, in which a venture capitalist invests a certain amount in a company, and in return is given some percentage ownership and is also entitled to take part in major decisions and policy reforms.
• Then comes Debt, which you all know is borrowing money from banks at the cost of collateral.

 

Now, before I start my surgical analysis on ROE, there is something you guys need to understand. Most people have this pre-conceived notion that these financial ratios are some hi-fi figures that economists calculate and it requires a qualified expertise to do so but truth be told that anyone can do it, be it a soccer player or an English teacher. No I'm not going to tell you some gibberish formula which will simply go over your head and frankly mine too.

Let’s illustrate this with a simple example. Say you own a company whose management team is highly efficient and recently your performance has been sensational compared to your peers as you shattered your own records by a high margin. So as an investor I would be interested in your business & do a simple analysis to find the ROE. Assuming your company has a total equity of 500cr. 250cr from shareholder's money and 250cr from Debt. Let's Say, 2019 was a profitable year & your Company netted a revenue of 100cr. Now keep in mind that this isn't the final amount which will come to your company's coffers as you'll also have to pay taxes and the interest amount on your debt.

 

 

To find out the net profit, I'll make use of basic math by deducting the interest amount say 10% of debt from the revenue. 10% of 250cr gives 25cr. So the net profit comes out to be 75cr, which I found out by subtracting the interest i.e. 25cr from the revenue i.e. 100cr. Now to calculate ROE I divide the net profit by 250cr which is the shareholder's equity. Finally, the ROE of your Company comes out to be 30%, which is phenomenal! But before coming to conclusions I would also check your peer company's ROE, which will give me a true insight on how your business is doing. Let's say that your peers have an average ROE of 25%, which would lead me to conclude that you are an amazing CEO.

Kudos!!

Now that you've got a hold of how to find out ROE, let me define it for you.

Return on equity (ROE) is a measure of financial performance which is calculated by dividing net profit by shareholders' equity. This provides the investors an insight into how effectively a company’s management team is using its assets which is the shareholder's money to create profits. Simple right? Let's delve deeper!

 

General thumb rule is, higher the ROE, more efficient a company's management is at generating income and growth. But this isn't always the case and I'll cover this later in detail. The formula I mentioned above is especially beneficial when comparing companies belonging to same industry since it tends to give an accurate indication of which one is operating with greater financial efficiency. Whether a company's ROE is deemed good or bad will depend on what is the average among its peers.

 

Pro Tip : Target an ROE that is equal to or above the average for the peer group.

 

Now you might be wondering why an average or slightly above average rather than an ROE that is double or triple the average of their peer group. Aren’t stocks with a very high ROE a better value?

 

Sometimes a higher than usual ROE is a good thing if net profit of a company is extremely high compared to the shareholder's equity because that would indicate a next level efficiency. However, an extremely high ROE can also be an alerting sign.

 

An unusually higher than average ROE can happen mainly due to inconsistency in generating profits. Imagine there's a company ABC that has been unprofitable for several years. The losses keep adding up year after year and because they are a negative value on the balance sheet, shareholder's equity is used up to neutralize the losses. But in the most recent year ABC has a turn around and makes a profit. Going by the formula, the denominator which is the shareholders equity in the ROE calculation is now very small after many years of losses, add to that the recent profit which when used in numerator to calculate the company's ROE will make it misleadingly high.

 

Pro Tip : Whenever you come across an unusually high ROE, make sure that you check the past profit records so that the ROE doesn't mislead you.

 

By Now I'm sure you must've understood why ROE is a really important metric for all the stock investors out there. For financial nerds, my article on P/E Ratio is worth checking out. More importantly, you have now taken the first step in learning how to pick quality stocks to add to your portfolio and grow your wealth.

Happy Learning!!

Note : All images used in this post has been taken from Google Images and the copyright of each of the images lies with their copyright holders.

The views expressed above are personal and belong to the author.

This post has been written by Somaditya Singh.

Also See : P/E Ratio