Friday 13 October 2017

Return on Equity (RoE)

Return on Equity (ROE)



The Return on Equity (ROE) is a very important ratio, as it helps the investor assess the return the shareholder earns for every unit of capital invested. ROE measures the entity’s ability to generate profits from the shareholder's investments. In other words, RoE shows the efficiency of the company in terms of generating profits to its shareholders. Obviously, higher the RoE, the better it is for the shareholders. In fact, this is one of the key ratios that help the investor identify investable attributes of the company. To give you a perspective, the average RoE of top Indian companies vary between 14 – 16%. I personally prefer to invest in companies that have a RoE of 18% upwards.
This ratio is compared with the other companies in the same industry and is also observed over time.

Also note, if the RoE is high, it means a good amount of cash is being generated by the company, hence the need for external funds is less. Thus a higher ROE indicates a higher level of management performance.

RoE can be calculated as: [Net Profit / Shareholders Equity* 100]

There is no doubt that RoE is an important ratio to calculate, but like any other financial ratios, it also has a few drawbacks. To help you understand its drawbacks, consider this hypothetical example.Assume Vishal runs a Pizza store. To bake pizza’s Vishal needs an oven which costs him Rs.10,000/-. The oven is an asset to Vishal’s business. He procures the oven from his own funds and seeks no external debt. At this stage, you would agree on his balance sheet he has a shareholder equity of Rs.10,000 and assets equivalent to Rs.10,000.

Now, assume in his first year of operation, Vishal generates a profit of Rs.2500/-. 

What is his RoE?

This is quite simple to compute: RoE = 2500/10000*100 =25.0%.

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