What is Return on Equity (ROE) in the Stock Market?

Return on Equity is a financial performance that defines the company’s profitability and its ability to generate profit. If ROE indicates a high figure that means the company has a good and efficient management system. The ROE in the stock market is expressed through a percentage. In this blog, we will explore the return on equity meaning, return on equity example, how to calculate it, how to use ROE, and a lot more. 

How to use ROE?

ROE can be used in the following ways. 

1. Payment of Dividends: Keep a watch on companies with a high return on equity because these companies will have greater profits. This significantly indicates that they will pay higher dividends to their shareholders.  
2. Calculating Growth: To calculate a company’s growth rate, it is important to know the return on equity. When the ROE is high but the company is paying low dividends this means that the company will invest more profits into its growth which will lead to future earnings.  
3. DuPont Analysis: The DuPont Analysis is a great financial tool used by investors. With the help of DuPont analysis, investors can break down the return on equity into different components for a clear understanding of how profitable the company will be. 

The formula is:

ROE (Return on Equity) = (Net Income/Sales Revenue) X (Sales Revenue/Total Firm Assets) X (Total Firm Assets/Shareholder Equity)

Formula to Calculate ROE

Now that you understand the ROE meaning in the stock market and how to use ROE, let's now understand the formula to calculate ROE.

Return on Equity (ROE) = Net Income / Equity of the Shareholders

Here:

• Net income describes the company's overall profit during a certain period after its tax payments, which can be determined from the income statement.
• Equity of the shareholders is the total equity that the shareholders have, including both retained and common stock which are found in the company's balance sheet.

How to Calculate ROE?

To calculate ROE, both the net income and shareholder’s equity should be positive. Here is a return on equity example for a better understanding:

Suppose, if ₹6 of shareholders' equity generates ₹1.20 in net income, the ROE would be 20%. For a clearer return on equity example, consider the following table:

Using this data here’s how we calculate it:  

ROE=  4,30,000​ / 7,20,000 =0.597

Return on Equity=0.597×100=59.7%

With the help of this example, we can see that the ROE is 59.7%. This indicates that there is strong profitability relative to shareholders' equity.

How to Interpret the Return on Equity to Analyze Companies?

Here's how to interpret ROE when analyzing companies: 

• Compare to Industry Averages:

Different industries have different ROEs. If there is a good ROE in one sector then it may not be ideal in the other sector. To get the correct results of ROE it is important to compare it with the average ROE of companies in the same sector. A high ROE will suggest that there is profitability and efficient use of shareholders' capital. 

• Check for Debt Levels:

There can be excess debts in high ROE. It is important to compare the debt-to-equity ratio of the company to ensure that its high ROE isn’t because of the financial leverage. This will help determine if the company's profitability is healthy or if it's relying heavily on borrowing.

Limitations Of ROE - Why is ROE Considered an Imperfect Scale?

After understanding what is the return on equity and how to use it, you should also be aware of its drawbacks. The following are the limitations of ROE:

• There is a huge influence of debt on ROE. If there is a high level of debt then the return on equity will get inflated. So if companies will take more debt their net income will increase without actually raising the ROE. This will the company look more profitable than it is but it can be at risk. 
• A high ROE may sound very appealing, but if this comes through risky ventures or high leverage, it may also constitute a warning of instability that will manifest in the longer term.
• The ROE is a measure that essentially relies on past information; this means it is based on past performance. It does not consider the future growth perspective or additional investments that may alter profitability.
• Different enterprises follow different accounting practices, and thereby, the net income and equity calculations may be affected.

Conclusion
We can conclude that ROE is a crucial financial indicator that assesses a company's profitability in proportion to its shareholder equity. Investors and analysts frequently use it to assess the effectiveness and success of a company's finances. Even though ROE has its limitations, it is still a useful tool for evaluating the financial stability and profitability of a business. To get a more complete picture of an organization's financial condition and risk profile, investors and analysts should combine ROE with other financial indicators and qualitative considerations. Additionally, if you are new to trading and need help understanding it, you may check out the user-friendly BlinkX Trading App, which provides online support and direction.