What is Return on Equity (ROE)?

Return on Equity (ROE) is a financial performance ratio that measures a company’s profitability and its ability to generate profit using shareholders’ funds. It shows how efficiently a company uses the equity invested by shareholders to earn returns. The return on equity in the stock market is expressed as a percentage and is commonly used by investors to evaluate the company’s management efficiency and financial strength. In this article, the ROE full form, how it works, how to calculate it, its advantages and disadvantages are discussed. 

How to Calculate ROE? 

Formula to Calculate ROE 

Return on Equity (ROE) = Net Income / Shareholders’ Equity 

Here: 

• Net Income: It represents the company’s overall profit during a specific period after paying taxes. It can be found in the company’s income statement.  
   
• Shareholders’ Equity: It represents the total funds invested by shareholders, including retained earnings and common stock, which can be found in the balance sheet. 

Example of ROE Calculation 

To calculate what is ROE in stock market, both net income and shareholders’ equity should be positive. 

Suppose ₹6 of shareholders’ equity generates ₹1.20 in net income. The ROE would be 20%. 

For a clearer understanding, consider the following example: 

Using this data, the calculation will be: 

ROE = 4,30,000 / 7,20,000  
ROE = 0.597  
Return on Equity = 0.597 × 100  
Return on Equity = 59.7% 

This indicates strong profitability compared to shareholders’ equity. 

How Return on Equity (ROE) Works? 

ROE in share market helps investors understand how well a company is generating profit using shareholders’ investments. It works in the following ways: 

• Measures Profitability: ROE shows how much profit a company earns for every rupee of shareholders’ equity.  
   
• Shows Management Efficiency: A higher ROE indicates that the company’s management is using available funds effectively.  
   
• Helps in Growth Evaluation: Companies with higher ROE often have better chances of reinvesting profits into business expansion and future growth.  
   
• Supports Investment Comparison: Investors use ROE to compare companies within the same industry to identify stronger performers.  
   
• Used in DuPont Analysis: ROE can be broken into components like profit margin, asset turnover, and financial leverage to understand profitability in detail. 

Advantages and Disadvantages of Return on Equity 

What is the Purpose of ROE to analyze Companies? 

Here's how ROE interpreted in stock market when analysing 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. 

Conclusion 

ROE is an important financial indicator that helps investors evaluate a company’s profitability in relation to shareholders’ equity. It provides insights into management efficiency and financial performance. Although ROE has certain limitations, it remains a useful tool when analysed along with other financial indicators. Investors who want to evaluate companies and participate in market opportunities can open online trading account to start analysing financial ratios and make informed investment decisions.