What is Return On Equity: Meaning, Formula, Advantages and Limitations

When assessing an enterprise's financial performance, investors account for financial metrics, such as the company’s cash flow, profit margins, and revenue growth. Only after accessing metrics like these an investor should place orders on their trading accounts. In this article, we will cover one such important metric—used to gauge the financial performance of the company—called Return on Equity (ROE). We will explore this ROE metric in depth to learn what it means, how to calculate it, and how to interpret it. 

What is ROE in the Stock Market?

To start off, let’s understand what the phrase “Return on Equity” in stock market actually means. The ROE of the company states how much profit the business makes for its shareholders, given the proportion of the stock they have purchased in the company. In simple words, the ROE portrays how efficiently a company uses its shareholders’ equity to generate profits. It is one of most widely used metrics to analyse a company’s profitability. Now that you have a basic understanding of what ROE means, let’s look at its formula. 

How to Calculate ROE?

The formula for calculating a company’s ROE is simple: you simply take the company’s net income and divide it by the shareholders’ equity. 

Return On Equity (ROE) Formula =  Net Income/Shareholders’ Equity

Sounds perplexing? It’s not; the net income is the company's retained profits after subtracting all expenditures, such as taxes, interest, and other outlays. You can easily obtain this figure from a  company’s income statement. 

On the other hand, the shareholders’ equity can be obtained by subtracting the firm’s liabilities from its assets. It is the value that shareholders have left in the business, after all debts and other commitments have been subtracted or settled. You can get this information from the company’s balance sheet.

Return On Equity Example

ROE is generally given in terms of a percentage. As an illustration, let’s assume a company made a net income of Rs.1 crore and shareholders' equity of Rs.10 crores, the ROE would be: 

ROE    = Rs.1 Crore / Rs.10 Crore

= 0.10 

= 10%.  

Silliarly, the ROE would be 20% if a business had net income of Rs.1 crore and shareholder equity of Rs.5 crores, using the ROE formula.  

How to Interpret the Return On Equity To Analyse Companies?

Given you know what return on equity, from the above ROE example, you may assume the following: high ROE indicates a superior business, and low ROE indicates a subpar business. A higher ROE ratio signifies a firm is running more effectively and producing more returns for its shareholders than an entity with a lower ratio. Well, sort of since this interpretation is very rudimentary; one has to account for several other factors while analysing the business, such as the nature of the business and its debts. 

For example, IT companies that generally have higher profit margins than capital goods manufacturing companies are likely to always have a higher ROE than the latter. So even a subpar IT company may possess a ROE of 20%, while a robust capital goods manufacturing firm may only exhibit an ROE of 17%. If you only account for the ROE, you will choose the subpar IT company over the robust capital goods manufacturing firm. Hence, it is crucial to compare a company's ROE to that of its competitors because ROE ratios can range significantly across various businesses and sectors. 

If a company's ROE is higher than its peers, it indicates the company has a competitive edge, good management, and a higher efficiency than that of its peers. On the other hand, a low ROE might imply the reverse. 

Limitations Of Using Return On Equity

However, it is essential to remember that ROE has its flaws and is not a perfect metric. The main critique of the ROE metric is that it does not account for debt. If a company takes on a lot of debt, it could very well increase its profits and generate a greater ROE than those that just use stock to fund their operations. A company’s debt is something investor's want to track closely because if the company defaults on its debt it can go bankrupt. Which is why many investors prefer using the ROCE (return on capital employed) as it is a ratio that accounts for the company's liabilities. 

Likewise, the second drawback of the metric arises if there are share repurchases or changes to a company's capital structure might affect ROE. For instance, if a business buys back a significant number of its shares, its shareholders’ equity decreases, and even the profits stagnate, the ROE will increase. 

Lastly, the ROE is a lagging indicator, so it doesn’t guarantee the company will be able to sustain its ROE. It may just be the case that the company generated a high ROE at peak operating margins, only for the operating margins to decline thereon, which will result in lower ROE margins the next quarter. Likewise, if a robust company incurred a one time major expense, the ROE will appear depressed, and investors solely looking at ROE margins may look past the company. 

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 organisation'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.