What Is Return on Equity(ROE) ?
As the name says Return on Equity, ROE is the income generated from per unit of equity invested, in simple words how much returns shareholders or investors are getting on the money invested by them in the company.
RoE calculate the companies ability to generate profits from the shareholder’s investments. In other words, RoE shows how efficient the company in terms of generating profits to its shareholders.
Hence it is quite Obvious that higher the RoE, the better it is for the shareholders. Therefore if you want to find out the investable attributes of any entity always look for its RoE.
Another point to keep in mind, if the RoE is high, it reflects that a good amount of cash is being generated by that company. Hence they do not need much external funds, thus a higher ROE indicates a higher level of management performance.
Needless to say RoE is compared with the other companies in the same industry (Peers) and is also observed over a long time frame. That is to say look for atleast last 5 year RoE to better check the consistency for any company.
How ROE Is Calculated?
The formula to calculate RoE is very simple and straightforward:
ROE can be calculated as = PAT (income statement) / Total shareholder’s equity (balance sheet)*100
In above equation PAT i.e. Profit After Tax is also refer to as Net Income, Net earnings or net profit or the bottom line.
Just to let you know PAT numbers are accessible in Profit and Loss statement and shareholder equity is in balance sheet both can be found in any companies annual report.
Let us understand how to calculate RoE through a simple example,
Standalone Financial statements represent the company’s standalone numbers/ financials and do not include its subsidiaries’ financials.
Whereas, the consolidated numbers include the companies (i.e. Standalone financials) and its subsidiaries financial statements.
Hence you should look through the consolidated financial statements as it represent the company’s financial position better.
Let us look at the P&L statement (this is half part covering only PAT) of Tata Motors Limited (TML) .
As you can see from the snapshot above, to arrive at the profit after tax (PAT), we need to deduct all the applicable tax expenses from the PBT. Hence, TML has total profit and loss for FY21 of about Rs.(-13,451.39). FYI, the number in bracket are negative.
Now, if check the Balance sheet will get the TML total shareholder’s equity, check out the below snapshot:
As, visible the total shareholders equity stands at Rs.56,820.21 cr, now using the above RoE formula let us calculate it:
RoE = -13451.39/56,820.21*100 = -23%
Do note that not all returns will be credited to the investor’s account. The company might decide to return only some amount as dividend and retain the rest for future investment purpose.
However since all profits generated by the company, technically belong to the investors we use the same for return calculation.
Hence this reflects TML have generated negative returns for the shareholders or investors of the company, which obviously is not good at all, however we know its due to the pandemic as well as problems face during EU Brexit due to which its one of the leading subsidiary Jaguar faced lot of trouble in 2019-2020.
Even, If we see the last 3 year trends TML have been continuously giving negative RoE of average –27% and last 5 year average stands at -12%. However, since this quarter company do have performed better if you check the quarterly results.
One should always look at the ROE history of a company to understand how much returns can be expected in the future. ROE also helps in comparing two different companies.
However please make sure that only apples are compared to apples, i.e. similar companies from same sectors should be compared to each other.
Let’s consider an example to understand how the ratio can be used by individual investors. Suppose you have Rs 10,000 and are thinking whether to invest in XYZ Inc or a bank fixed deposit.
Bank is offering 8% returns for a one year fixed deposit. However you are aware that XYZ Inc. generated 18% returns last year.
If you believe that XYZ Inc. will continue to perform well and be able to sustain its profitability, then the company will probably generate 18% returns next year as well. Hence it would make sense to invest in XYZ Inc. compared to bank fixed deposit.
One argument against investing in XYZ Inc. is that past performance doesn’t guarantee any future performance and that the company might not generate high returns next year.
But suppose XYZ Inc. has continuously generated ROE of 18% over the previous 5 years, then there is a good chance that company might do this in the future as well.
What Is a Good ROE?
Any RoE between 14 – 16% can be counted as a good RoE, having said that I personally prefer to invest in companies that have an RoE of atleast 18% upwards.
But keep in mind A high RoE is great, but certainly not at the cost of high debt. The problem is with a high amount of debt, running the business gets very risky as the finance cost increases drastically. For this reason, you should also check the companies debt, so inspecting the RoE closely becomes extremely important.
I hope now you have the basic understanding of what is RoE and how to calculate it, But this is not the end, there are financial statements you should read and understand i.e. Balance sheet, Cash Flow Statement and profit and loss statement to gauge the complete knowledge about how company have performed in an financial year.
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