Return on Equity: Benefits, limits and Investment Role

When seasoned investors are looking for a stock or mutual fund, they do not invest based on the latest trends or news. Instead, they use different financial metrics to evaluate companies or mutual funds to find the stock or mutual fund that suits their investment goals and investment horizon and is more likely to generate profit. Return on Equity (ROE) is one of the crucial financial metrics they use to evaluate a company's profitability relative to shareholders' equity.

Let’s understand what is the ROE ratio, how to calculate it and what are the benefits of the ROE ratio.

• Table of contents

• What is the return on equity ratio?
• How is the ROE ratio calculated?
• What are the benefits of the ROE ratio?
• What are the limitations of the ROE ratio?
• Return on equity ratio analysis
• Return on equity ratio (ROE) vs. return on invested capital (ROIC)
• Return on equity ratio and mutual funds

What is the return on equity ratio?

ROE is a profitability ratio that measures the ability of a firm to generate earnings from the equity of its shareholders. Return on equity ratio is a key indicator of the financial efficiency of the company and reveals how well it is utilising its capital to create profits. Investors rely on this metric to compare companies within the same industry and to assess management effectiveness in using equity capital.

How is the ROE ratio calculated?

Here is the simple formula for ROE calculation:

        Return on Equity Ratio=(Net Income ÷ Shareholder^' s Equity) × 100

Where:

• Net income is total earnings after deducting all the taxes and expenses.
• Shareholders’ equity is the total capital invested by shareholders, including retained earnings.

For example, if a company has a net income of Rs. 10 crore and shareholders’ equity of Rs. 50 crores, its return on equity ratio would be = (Rs. 10 crores / Rs.50 crores) × 100 = 20%. This means the company generates a 20% return on every rupee of shareholders’ equity.

What are the benefits of the ROE ratio?

Now that you know the ROE ratio meaning, you need to know the benefits of the ROE ratio when assessing a company’s financial performance. They are:

• Indicator of profitability: A higher ROE signifies strong profitability of a company. It demonstrates that the company effectively generates profits with its available equity. A consistently high ROE makes a company attractive to investors, as it suggests sustainable growth potential.
• Use in comparative analysis: Investors can use the return on equity ratio to compare companies and find the ones with superior financial performance. It is important to note that ROE must be used to compare companies within the same industry for a reliable result.
• Evaluation of the management: ROE ratio helps determine how efficiently a company's management is utilising shareholders' capital to create growth. Fund managers often use ROE to pick up stocks of different companies for mutual funds.

What are the limitations of the ROE ratio?

Despite the many benefits of the ROE Ratio, it has some limitations and should be used with other metrics to make investment decisions.

• Influence of debt levels: Companies with high debt levels may inflate the ROE ratio because liabilities are not factored into the equation. In addition to this, some companies may use accounting techniques to artificially boost return on equity ratio, misleading investors about their actual profitability.
• Limited application: ROE can vary significantly across industries. This makes it less useful when comparing companies from different sectors. It is recommended that the ROE of companies of similar size in the same industry sector be compared.
• Ignores risk: The return on equity ratio does not reflect the level of financial risk taken by a company to achieve its returns. If a company experiences fluctuations in earnings, its ROE may vary significantly and make it challenging to carry out a long-term trend analysis.

Return on equity ratio analysis

To effectively analyse ROE, investors should consider additional financial metrics such as:

• Debt-to-equity ratio: It helps determine whether a company’s high return on equity ratio is a result of excessive debt.
• Return on assets (ROA): It evaluates a company’s profitability relative to its total assets.
• Net profit margin: It indicates how much profit a company generates from its total revenue.
• Equity growth rate: It helps in assessing whether the company can maintain its ROE over time.

Return on equity ratio (ROE) vs. return on invested capital (ROIC)

While the return on equity ratio considers only shareholders' equity, ROIC includes both debt and equity and provides a broader view of profitability. Companies with high debt may have an artificially high ROE, but ROIC accounts for debt costs which means that it offers a more accurate measure in comparison. Investors often use both ROE and ROIC to gain a deeper understanding of a company’s financial performance and sustainability.

Return on equity ratio and mutual funds

Mutual funds, particularly equity funds, use ROE as a key metric when selecting stocks for their portfolios. A mutual fund that focuses on high-ROE companies is likely to invest in businesses with strong profitability, efficient capital utilisation, and potential for sustained growth.

In conclusion, return on equity (ROE) is a valuable financial metric that helps investors and analysts assess a company's profitability relative to shareholders’ equity. While it offers insights into profitability, management efficiency, and investment attractiveness, it also has limitations, particularly when used in isolation. To make informed investment decisions, it is essential to analyse the return on equity ratio alongside other financial metrics such as ROIC, ROA, and the debt-to-equity ratio.

FAQs:

What is a good ROE ratio?

A good return on equity ratio typically falls between 15% and 20%, depending on the industry. Companies with consistently high ROE indicate strong profitability and efficient capital use. However, excessively high ROE may result from high debt levels, so it is essential to analyse other financial metrics in addition to the ROE ratio.

What does a high return on equity ratio mean?

A high ROE indicates strong profitability, efficient capital utilisation, and effective management. It suggests the company generates high returns on shareholders' equity, making it attractive to investors. However, in some cases, a high ROE may indicate high financial leverage or accounting distortions.

What is the difference between ROI and ROE?

ROI (return on investment) measures overall profitability relative to the total investment, including debt and equity whereas the return on equity ratio specifically evaluates profitability concerning shareholders’ equity.

Why is the return on equity ratio important?

ROE measures a company's profitability and efficiency in using shareholders' capital. It helps investors assess financial health, management effectiveness, and potential for sustainable growth of a company. It helps them in making investment decisions.

What happens if ROE is negative?

A negative return on equity (ROE) is not a good sign. It shows that the company has incurred a net loss, leading to an erosion of shareholders’ equity. This could indicate poor financial health, inefficient operations, or excessive debt. It lets investors know that investing in such a company carries a higher level of risk.

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