What is ROE in Share Market? The Real Test of a Company’s Profitability???

Return on equity or ROE is a widely known and common term in the world of stock market. The measurement or analysis of a company’s performance in a given period is called return on equity. In order to determine the ROE, the net income of the company is divided by the shareholders’ equity.

Before moving ahead, here is some more clarity. Net income is the profit of the company after deducting tax, amortization, depreciation, expenses, etc. Shareholder’s equity is the remaining profits after all debts related to the business have been paid.

With that out of the way, let’s get a better understanding of ROE.

Content:

• Return on Equity Meaning
• ROE Formula
• How to use ROE for Investment?
• Highest ROE Stocks in India
• Stocks with High ROE and Low Debt in India
• Quick Summary
• FAQ

Return on Equity Meaning

The return on equity (ROE) is a measure of a company’s profitability in relation to its equity. ROE can also be thought of as a return on assets minus liabilities because shareholder’s equity can be computed by adding all assets and removing all liabilities. 

ROE calculates how much profit is earned for every rupee of shareholder equity. ROE measures how well a company uses its equity to produce profits.

What it also does is provide an insight into the company’s investments and management of equities. No wonder intelligent investors do take the ROE of a company into consideration before investing their hard-earned money. Keep reading to find out what is return on equity in a more clearer way.

ROE Formula

The basic return on equity formula is:

Return on Equity = Net Income/Shareholder Equity

Now, to calculate ROE, both net income and shareholder equity need to be positive for the company. 

Here, net income is the bottom-line profit of the firm, as shown in the income statement. 

Shareholder equity is the subtraction of liabilities from the assets after the company settles its liabilities.

Consider this ROE formula example: Let’s say an IT major has a net income of ₹10,00,000. And the shareholder equity is ₹45,00,000. Therefore, going by the formula: 10,00,000/45,00,000 = 0.22

Hence, the ROE of this company will be 22.22%. Hopefully, you have understood how to calculate ROE.

How to use ROE for Investment?

Understanding the return on equity of a company can be tricky. If the stockholders increase investment in a given stock, it will take the ROE up. This will also indicate a certain level of trust in the company. 

Fund managers and investors make it a point to often use ROE to gauge the growth potential of the company since the return on equity limits the capability of growth and expansion. 

ROE is subjective. For certain sectors, an ROE of 15% may indicate substantial growth, while 25% ROE in other sectors may mean only decent performance.

Also, lower ROE does not mean that the company is not performing well. It may mean that the company would have used some money to buy machinery for usage or would have made any internal investment. While this will bring down the ROE, it will be only temporarily.

Just seeing the ROE is not enough. One needs to look at the variables and analyze them rather than just seeing the end result of the calculation. If the equity investment falls, it means that the company is suffering. See for yourself below…

Let’s say a company has a net income of ₹6 crores in a given year, and the shareholders’ equity came at ₹40 crores. Hence, the ROE would be 6/40 multiplied by 100, which is 15%.

Now, the same company had a similar net income of ₹6 crores next year. But, this time, the equity from shareholders dropped to ₹10 crores. Now, this will lead to the ROE quadrupling to 60%. 

The key thing here is that the shareholder equity has gone down. This reflects that the company is not doing well enough.

Highest ROE Stocks in India

Here are the top 10 Highest ROE stocks in India

Stock with High ROE and Low Debt in India

Here are the top 10 stocks with high ROE and low debt in India

Disclaimer: The above article is written for educational purposes. The securities quoted are exemplary and are not recommendatory.

Quick Summary

• The measurement or analysis of a company’s performance in a given period is called return on equity
• Net income is the profit of the company after deducting tax, amortization, depreciation, expenses, etc. 
• Shareholder’s equity is the remaining profits after all debts related to the business have been paid.
• The basic return on equity formula is: Return on Equity = Net income/Shareholder equity
• ROE is subjective. 
• For certain sectors, an ROE of 15% may indicate substantial growth, while 25% ROE in other sectors may mean only decent performance.

FAQ

1. What is a Good ROE?

As stated earlier, ROE is subjective, and it depends and varies from sector to sector. However, if the ROE is above market average, then it is considered to be good ROE. The market average keeps changing based on the performance of the stocks.

2. What is ROE Ratio?

ROE ratio is a financial ratio that helps gauge a company’s ability to generate profits from the investments of the shareholders. It helps to measure the company’s effectiveness in using equity funding to run daily operations. 

The return on equity ratio formula is

Return on equity = Net income / Average shareholder’s equity