Stock / Share Market
Last Updated: 2023-04-21T11:25:31+05:30

## Return on Equity

Do you want to invest in a company's shares? If so, what are the things that you will consider before making the decision? In abstract terms, the most common criterion would be the business's profitability. Return On Equity (ROE) is a significant financial ratio that gauges a company's profitability in relation to its book value.

## What Is Return On Equity (ROE)?

Return On Equity is a profitability ratio that indicates how good the company is at making profits out of the equity capital.

In doing so, a company will satisfy its investors and create a sense of goodwill. In financial terms, Return On Equity is the ratio between the net income and the total amount of shareholder's Equity.

A higher ROE will indicate that the company is efficient at generating profits through equity financing.

It should be borne in mind that the ROE cannot be used as a comparison for companies across various sectors. Because it depends on the industry or sector in which the company operates.

## Calculating Return On Equity (ROE)

The formula for calculating Return On Equity is as follows:

Return On Equity (ROE)  = Annual net income/Total shareholder's Equity

Now, let us understand the terms of the above equation in detail.

1. Annual Net Income: The net income is the bottom-line profit of a company. It can be obtained from the company's Income Statement for the year under consideration. It is arrived at by deducting the operational expense, interests, and taxes from the annual revenue. The formula can be written as Net income =  Gross Revenue - Expenses (inclusive of interest expenses for outstanding debts) - Taxes.

2. Total Shareholder's Equity: Shareholder's Equity is an investor or shareholder's claim over the company's assets after adjusting liabilities. It can be obtained from the company's balance sheet using the following simple formula: Total Shareholder's Equity = Total assets - total liabilities.
It is essential to understand that there will be a slight mismatch in the equity value between the income statement and the balance sheet to overcome this, it is advisable to use the average Equity over the period considered.

For a more intuitive understanding, the Return On Equity formula can be seen as a product of Return On Assets (ROA) and financial leverage.
Return On Assets will be the ratio between net income and total assets in such a case. Financial leverage will be the ratio between total assets and total shareholder's Equity.

The above method of expressing Return On Equity gives the investor an understanding that both ROA and financial leverage are functions of ROE.

## Return On Equity And Stock Performance

Return On Equity is one of the ratios used to paint a somewhat accurate picture of a stock's performance. It is a ratio that talks about the efficiency of a company in milking out profits.

Higher efficiency translates to an effective organization and a profitable business with an inherent market competitive advantage.

Let's take the example of Lupin Limited's average ROE over the financial years 2012-2016. The Indian multinational pharmaceutical company had an average ROE of 26.45%.

Compared to the average ROE of the entire pharmaceutical industry in India during that period, Lupin exhibited above-average ROE.

Consequently, Lupin Limited's shareholders enjoyed an enormous stock price hike over these years. Hence it is pretty evident that Return On Equity closely captures stock performance.

But this might not be the case always. Therefore other ratios are used simultaneously to analyze the stock performance better.

## ROE And A Sustainable Growth Rate

A Sustainable Growth Rate (SGR) is the maximum growth a company can attain with its current level of funding. That is without the necessity of bringing in additional capital through debts or issuing fresh Equity. The formula for calculating SGR is as follows:

SGR = ROE x Retention ratio (or) SGR = ROE x (1-Payout ratio)

It is crucial to compute the SGR while making investment decisions because any mismatch between the company's growth and the Sustainable Growth Rate might need more information.

For instance, Company A, with a higher ROE than Company B, might still project a comparatively lower Sustainable Growth Rate.

## How To Calculate ROE Using Excel?

Return On Equity can be calculated using Excel using the same formula mentioned above. First, the annual net income must be obtained by subtracting the expense and tax items from the gross revenue.

Consider that the annual net income is in Cell B20. Similarly, the total shareholder's Equity must be obtained by subtracting total liabilities from total assets. Consider it is in Cell B30. Now ROE is calculated using the formula =B20/B30.

## What Is A Good ROE?

A good ROE can be suggested only based on the industry. As we have already discussed, ROE cannot be compared for companies from different sectors or industries.

Because generally, an ROE of 15-20% is considered good. Only an ROE greater than 25% in some industries is considered good.

## What Is The Difference Between Return On Assets (ROA) And ROE?

While both Return On Assets (ROA) and Return On Equity (ROE) measure a company's profitability, they are not the same. ROE does not consider financial leverage. But ROA does. ROE can be obtained by multiplying a company's Equity multiple and ROA.

## What Causes ROE To Increase?

By now, we have understood the return on equity meaning. The company's strong performance is the best reason for an increase in ROE.

That is, if the company's net income is substantial compared to its Equity.
However, a very high ROE doesn't equate to profitability always. ROE might also increase, including:

● Inconsistent profits
● Excess debts
● Negative net income

## Return On Equity Vs. Return On Invested Capital

There is only a meek difference between Return On Equity and Return On Invested Capital (ROC). ROE calculates profits concerning the Total Equity of the company.

At the same time, ROC calculates profits with reference to the company's total capital. The capital includes both Equity and debts.

## Example Of Return On Equity

TAAL Tech is a solution provider in the Engineering and Technology sector. The company is best known for its zero debts on the balance sheet.
TAAL Tech has a 5-year average ROE of 38.65%. The company has had an ROE of 32.33%, 41.70%, 34.20%, 37.65%, and 47.37% over the past 5 years.

Other companies with a high ROE in India include Gillette India Limited, Manappuram Finance Limited, Bajaj Consumer Care Limited, and Hawkins Cookers Limited.

## Limitations Of Return On Equity

Although ROE is an excellent indicator of a company's performance, it cannot be used as an exclusive tool. Also, a high ROE may not always indicate higher growth or profits. It may mislead investors in case the company has excess debts.

Sometimes, negative shareholder equity will exist. In such cases, ROE cannot be used to compute the company's performance.

It is essential to understand both the advantages and limitations of ROE. It must be used along with other relevant indicators for a more accurate measurement of profits and risks involved.

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