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Return on Equity (ROE)

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How profitable is a company, relative to its book value?

This is what return on equity (RoE) measures.

A company's equity, or book value, is total assets minus total liabilities. In other words, if you sold off all the assets, paid off all the debts, equity is what you would be left with.

The RoE tells us how much profit the firm generates for each rupee of equity it owns.

For example, a firm with a RoE of 10% means that they generate a profit of Rs 10 for every Rs 100 of equity it owns. RoE is a measure of the profitability of the firm.

It also depends on a firm's total leverage or debt level. For a given level of assets, the higher the liabilities (debt), the lower the equity.

And the lower the equity, the higher the return on equity.

This is critical to keep in mind when comparing the RoE across firms.

Sometimes, a firm can have a higher RoE because it has more debt, not because it is actually more profitable. Thus, it is best to compare RoE across firms with similar levels of debt or leverage.

Typically, firms in the same industry will have similar levels of debt or leverage.

The RoE is computed entirely from a company's accounts. This is unlike indicators such as the P/BV ratio, which uses the share price as well as accounting information.

While RoE measures how profitable a firm is relative to its book value, the P/BV ratio tells us the price of the stock, relative to its book value.

This means that the RoE does not tell us anything about whether the firm's stock is cheap or expensive. It tells us only whether the firm is profitable or not.

The Return on Equity Formula

The RoE is the net income from the firm's most recent income statement, divided by the total equity at the end of the period.

The income statement is measured over a period of time (i.e. one year), whereas equity is measured at a single point in time.

Total equity is equal to total assets minus total liabilities, which is the same as the book value of the firm.

RoE = 100% * (net income / total equity)
where, Total Equity = Total Assets - Total Liabilities

An alternative calculation uses the average total equity, where we compute the average value of equity between the start and end of the year.

Calculating the Return on Equity: An Example

Suppose Bajaj Auto's most recent net income is Rs 3,828 crores and their total equity is Rs 17,034 crores.

Using our formula gives us a RoE of 22.5% for Bajaj Auto.

Bajaj Auto RoE = 100% * (Rs 3,828 crore / Rs 17,034 crore) = 22.5%

Comparing Return on Equity with Other Indicators

How does the RoE compare to other indicators, such as return on assets (RoA) or return on invested capital (RoIC)?

These three indicators all aim to answer the same question - How profitable is the company?

All three indicators use only accounting variables and no market variables. This means that they do not tell us whether the stock is cheap or expensive. They tell us only how profitable the company is.

RoA uses total assets in the denominator instead of total equity. Since assets are always larger than equity, RoA is always smaller than RoE. If liabilities are large relative to assets, then there is a big difference between RoE and RoA.

RoA can be a better comparison between firms that have different debt levels or leverage.

The RoIC is a more complex measure that aims to better capture a company's profitability from its core operations. Instead of using net income in the numerator, it uses net operating profit after taxes.

This removes any income that does not come from a company's core operations. The denominator uses total capital instead of total equity. This is done by removing cash and current liabilities so that only capital used to operate the business is considered.

Recommended Reading

Here are links to some very insightful Equitymaster articles and videos on Return on Equity

Happy Investing!

FAQs on Return on Equity

1. What is the Return on Equity (ROE) Formula?

The return on equity (ROE) is the net income from the firm's most recent income statement, divided by the total equity at the end of the period.

ROE = 100% * (net income / total equity)

Equitymaster has a screener which can help you find high ROE companies. You can start you search there.

2. Why is the Return on Equity (ROE) important?

The ROE (Return on Equity) is one of the most important criteria when filtering stocks to invest in.

ROE represents a firm's ability to generate returns for its shareholders. It tells us how much profit the firm generates for each rupee of equity it owns.

If a company has a low ROE, it means it has not used the capital invested by shareholders efficiently and vice versa.

3. How to use Return on Equity (ROE) to identify Multibagger stocks?

It's no secret that companies with high return ratios generate good returns for their shareholders.

To identify multibagger stocks with the help of ROE, check the ROE trend for the past five or seven years. It should show a consistent and increasing trend.

A steady and rising ROE is an indicator that management is giving shareholders more for their money.

4. What is a good Return on Equity (ROE)?

While there's no set criteria, a return on equity (ROE) of 15-20% is considered good.

It also depends on the specific industry the company is involved in because different companies have varying levels of assets and debt on their balance sheet.

Check out Equitymaster's Stock Screener to find high ROE companies. The screener allows you to screen stocks based on your own criteria.

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