Fundamental analysis is a technique that allows you to ascertain whether a company makes a good investment or not. It involves thoroughly examining the financials of the company with a fine-toothed comb. The return on equity (ROE) is one of the many financial ratios you need to look at when performing fundamental analysis. Wondering what it is and how this ratio is calculated? Continue reading to find out.
What is Return on Equity?
Return on equity (ROE) is a financial ratio that indicates just how well a company has generated returns using the investment made by its shareholders. To put it in simple terms, ROE is the rate of return that the company’s shareholders receive.
Now that you’ve understood the meaning of return on equity, let’s take a look at how it is calculated. The calculation involves the use of a simple mathematical formula.
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Here, net income refers to the income after the deduction of interest, taxes and all other expenses from the revenue.
Return on Equity (ROE) - An Example
By using the above-mentioned return on equity ratio formula, you can quickly ascertain the value of almost any company. Let’s take a look at an example to see the formula in action.
Assume that there’s a company called ABC Limited. The total shareholders’ equity in the company comes up to about Rs. 50 lakhs. The gross revenue of the company for the year stands at Rs. 98 lakhs. The company is required to pay interest to the tune of Rs. 8 lakhs, whereas the tax component is Rs. 10 lakhs. Additionally, the company is also required to pay a dividend of about Rs. 7 lakhs to its preferred shareholders.
Before we proceed to use the return on equity ratio formula, let’s first find out the net income of the company.
Net Income = Rs. 98 lakhs - Rs. 8 lakhs - Rs. 10 lakhs - Rs. 7 lakhs
Net Income of ABC Limited = Rs. 73 lakhs
Now that we’ve ascertained the net income of ABC Limited, let’s try to substitute the values in the return on equity ratio formula
Return on Equity (ROE) of ABC Limited = Rs. 73 lakhs ÷ Rs. 50 lakhs
ROE of ABC Limited = 1.46
A return on equity of 1.46 effectively means that for every rupee invested by the company’s shareholders, they would get Rs. 1.46 back.
The Importance of Return on Equity (ROE)
An ROE of 1 means that the returns generated by the company are equal to the investment made by the shareholders. An ROE of less than 1, means that the company is not effectively utilizing the funds and that the shareholders are getting negative returns. An ROE of more than 1 signifies a positive return on investment from the shareholders’ perspective. A company should ideally have a return on equity of at least 1 to be considered a worthwhile investment.
However, sometimes the ROE by itself may not be able to give you a clear picture of whether a company is a good investment or not. Companies operating in certain industries such as airlines traditionally have negative ROE. Going solely by this ratio, companies in this industry shouldn’t be a good investment. However, that’s not the case.
When determining whether a stock is a good investment or not, it is always advisable to compare its ROE with that of its peers and the industry in which the company operates. This should give you a better picture of where the company currently stands.
The general rule of thumb is to try and invest in companies with an ROE that’s higher than or at least equal to the average of the industry. Also, when comparing the return on equity, you should always take multiple years into account and not just stick to a single year.
Conclusion
With this, you must now be well-versed in what return on equity is and how to calculate it. The ROE is a good financial ratio that you can use to determine a company’s worth. However, it is inadvisable to solely rely on this one single ratio. A company whose major source of financing is from debt and not equity would report a high ROE. But that doesn’t mean it is a good investment.
Therefore, when you’re analysing a company fundamentally, always take multiple financial ratios into account. This will give you a much better context of the company’s finances and can enable you to take a more objective investment decision.