What is Return on Equity (ROE)?

Return on Equity (ROE) measures how effectively a company uses its shareholder’s equity to generate profits.

Shareholder’s equity is the money put in by investors in the company through stock/share buying from the Share Market.

ROE is a key financial ratio for investors to evaluate a company’s profitability.

How is ROE Calculated?

Return on Equity (ROE) is calculated using this formula:

ROE = (Net Income / Shareholders’ Equity) × 100

Example:

If a company has a net income of $100,000 and shareholders’ equity of $500,000, the ROE would be:

ROE = ($100,000 / $500,000) × 100 = 20%

This means the company generates a 20% return on every dollar of equity.

Ideally, a company having a consistent RoE of 15-20% is considered a wealth creator.

Please note: You can change Dollar to Rupee or Yen or Yuan or Euro or AUD – the concept remains the same

Why is ROE Important for Investors?

• Profitability Indicator: A higher ROE means the company is efficiently using equity to generate profits, signaling potential growth
• Comparison Tool: ROE helps compare the financial performance of different companies in the same industry
• Long-Term Value: Consistently high ROE can indicate strong management and sustainable profitability, making it an attractive stock

Things to Consider while using RoE:

• A very high ROE may be due to high debt, which can be risky (to check this – an investor will have to research the balance sheet of the company)
• Compare ROE within the same industry, as different sectors have different benchmarks.

Despite ROE not being the only factor in evaluating a business to invest in through the stock market, understanding ROE helps investors make informed decisions, ensuring they choose companies with strong financial health and potential for growth.

Hope you find this helpful

Other concepts essential in business evaluation will be shared in the coming posts.

All the best in your financial journey

God Bless!