Understanding Return on Equity (ROE) Ratio

The Return on Equity (ROE) is a profitability metric that measures a company's ability to generate profits using its shareholder's fund. ROE is calculated by dividing Net Income by Shareholders' Fund.

A higher ratio indicates how well the company is utilizing its equity to generate profit. ROE is commonly expressed as a percentage. And it is utilized in all screeners and charts throughout the site.

The formula to derive ROE



Net Income - Net Profit or Net Income is measured by sales minus the Cost of goods sold, general and administrative expenses, operating expenses, other expenses, depreciation, interest, and taxes, etc. Net Profit is found in the Income statement of the company.

Shareholder's Equity - Shareholders Equity or Shareholders Fund is the amount of equity that belongs to the shareholder of the company. It is found in the Company's Balance Sheet.

Example of Return on Equity: ITC Limited reported its Net Income of Rs. 13161.19 cr. And the Shareholders Fund as Rs. 60347.34 cr. for the financial year.
The ROE for ITC Limited, as per the formula (ROE = Net Income/Total Shareholders Fund x100) is calculated as (13161.19 / 60347.34)x100 = 21.81%.

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Key Highlights

ROE measures the company's ability in generating profit using its shareholder's equity. It is expressed as a percentage.

ROE of 15 % is considered good for most industries.

High ROE may indicate the company is utilizing its shareholder's equity effectively, but if the company has taken a lot of debt then also ROE will be higher.

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ROE is an independent metric, but while looking at ROE the following points should also take into consideration:

A higher ROE ratio indicates how well a company is utilizing its equity to generate revenue. ROE of 15% is considered good for most industries.

Gauging the ROE will allow analysts and investors to compare the performance very effectively of companies operating in the same sector.

ROE with less value is considered as the company is not managing its equity efficiently to generate revenue, but the company with a growing ROE yearly can be taken into account.

While analysing ROE always considered atleast five years of historical data. If the ROE is raising over years rather than sudden gain is plus point.

The value of ROE can be negative when the company has incurred losses for a period or borrowed money to continue business or to stay in the market. By then, company's liabilities will be greater than its assets. And if the company's Net Income is negative, then ROE will also be negative.

ROE is a profitability metric from the point of view of Investors as it shows how much a company is making a profit using shareholders' funds and also how well the company is utilizing or managing it.

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How to use ROE effectively

Investors should look for a company with a high ROE.

Lower ROE, but with continuous rising for years, means the company is becoming increasingly efficient in generating profit using shareholders' funds.

Even with a high ROE, investors should compare companies with their peers before making a trading decision.

While looking at ROE, also looked at ROE MRQ and ROE TTM for better understanding.

While looking at higher ROE, we must consider the factors behind it. A higher ROE value can be a warning sign in some scenarios, like a rise in debts or when a company buys back its shares.

ROE is an independent metric but it would be better to look at another financial metric with ROE like,Return on Capital Employed (ROCE) , Net Margin, Asset to Shareholders Equity, etc., for better analysis.

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Scenarios we must consider while looking at ROE:

Sudden Fall:

1. Sudden fall in ROE can be due to sudden fall in Net Income of the company.
2. Or gain in shareholders funds due an increase in a reserve capital company retains earnings.

Sudden Gain:

Sudden gain in ROE can be due to sudden gain in Net Income of the company.
Or fall in shareholders' funds.