How much do you know about ROE?
Or should we say, return on equity!
Investors or shareholders who are invested in the stock market usually check for performance ratios in order to find the company’s performance level and the profits it earns. There are many performance ratios or profitability metrics which help in proving that the company is performing well or not. Basically, it is a tool used by investors to get insights into how efficiently a company or its management team is handling the money that shareholders have contributed to it.
So, the higher the ROE, the more efficient a company is in generating income and growth from its equity financing. And when a company has low ROE, it clearly means that a company has not used the capital invested by shareholders in a productive way.
Even if you weren’t familiar with this profitability metric, now you do. So, let’s find out how we can calculate the ROE.
How to Calculate Return on Equity (ROE)?
The most simplistic way of calculating the return on equity is how many rupees of profit a company generates with each rupee of shareholders’ equity.
In other words, the net income (before common-stock dividends are paid) as the numerator and shareholders’ equity as a denominator.
Note: Free Cash Flow (FCF) can also be used instead of net income.
ROE = Net Income / Shareholders’ Equity
Importance of ROE
As discussed above, the ROI reflects whether the company is in the position of providing substantial returns to their investors or not.
According to market analysts and experts, the company’s ROE less than 12-14 percent is not satisfactory. However, if the value is above 20 percent then it would be considered a good investment. This is why many financial advisors suggest not investing in the companies that have negative ROE, especially in a volatile environment. The companies with negative ROE are likely to face excessive debt problems.
Also, it is important to measure the ROE of a company against a company in the same sector. It is because some industries have a high ROE as they require little assets but some companies require more infrastructures to generate more profits. Thus, it would be best t compare ROEs of companies in the same industry.
Final Thoughts: –
A company with a high return on equity has more intrinsic value and profits which can be used to provide good substantial returns to their investors. Thus, investors must know of this performance ration in order to make smart decisions regarding their investments.
The higher the ROE, the more easily, a company will be able to raise money for futuristic plans and projects.
If you have any query or would like to add something up then don’t forget to mention in the comment section given below.
Note: All information & data provided in this article is for the educational purpose as well as to give general information on the finance & economy, not to provide any professional advice or service. Views & opinions are not biased against the company and do not affect any official policy or any other agency, an organization within the content.