One of my friends recently started a small business. When we met the last week, she was excited to tell me about her new venture. She said that she invested Rs.50,000 of her own and Rs. 50,000 borrowed from her sister. After calculating the results for one month, she was left with Rs.1,05,000 out of which she repaid the borrowed principal from her sister and interest totaling Rs.51,000. It means using her own funds of Rs.50,000 she generated a profit of Rs.54,000.

After this meeting, I kept thinking about our little chat. I could not help but notice that we can do a similar kind of analysis when we're looking at companies to invest in. The parameter which does this analysis is known as ROE (Return on Equity). And so, to continue with our “What is ____?” series, I thought of explaining ROE today.

So, Let Us understand the next concept of this series: "What is ROE?"

ROE measures the entity’s ability to generate profits from the equity shareholder’s investments. In other words, ROE shows the efficiency of the company in terms of generating profits for its shareholders. The higher the ROE, the better it is for the shareholders. In fact, this is one of the key ratios that help the investor identify the companies in which he should invest.

ROE is calculated as follows:

ROE = [Profit attributable to Equity Shareholders / Average Shareholders’ Equity * 100]

Now that I have explained the theory of ROE, let me show the computation of ROE with the help of an example. Imagine a company called ABC Company Limited. I will calculate its ROE from the details given below:

Here,

Net Profit = 4,50,000

Shareholders Equity = [(Beginning Equity + Beginning Reserves and Surplus) + (Ending Equity + Ending Reserves and Surplus)] / 2

= [(10,00,000 + 25,00,000) + (10,00,000 + 29,50,000)] / 2

= 37,25,000

ROE = (4,50,000 / 37,25,000)*100 = 12.08%

This ROE can be compared to ABC Company's past period ROEs to see if it is increasing or decreasing. You can also compare it with other companies in the same sector to judge the efficiency of utilizing shareholders’ funds.

A higher percentage of ROE is generally considered a positive indicator. If the percentage is greater than its previous figures or higher than what similar companies are achieving, it is a positive sign.

Return on Equity (ROE) can also be applied to see how much profit a company makes for every rupee that its owners have invested. So, if the ROE of a company is 12.08%, it means for every one rupee invested by the shareholders, the company makes a profit of 12.08 paise.

But is High ROE always good?

While a high or very high ROE is often seen as advantageous, it's not always a positive indicator. If it's exceptionally high, it's important to investigate further, as profits might be manipulated or exceptional transactions during the period could be skewing the numbers. Moreover, a company might have a high ROE due to having more debt. Speaking of debt, the way borrowing costs are distributed, especially considering factors like moratorium periods for new loans, might lead to a temporarily inflated ROE. Additionally, a company with significant debt might show a higher ROE due to increased leverage. It is also important to note that comparing ROE across industries can be complex due to varying financial structures and company sizes within each industry.

However, despite its limitations, ROE is a key factor for investors in assessing a company's efficiency in generating returns from its equity investment.

In conclusion, while the importance of ROE is undeniable, prudent investors should complement ROE with other metrics like debt-to-equity ratio, CAGR of sales and profit, etc, and contextual information like exceptional items, etc. which will be covered in the upcoming blogs.