Return on Equity (RoE) is one of the most fundamental steps to measure profitability. Return on Equity (RoE) is important for investors because it reveals how much profit a company has earned after-tax in comparison to the total amount of shareholder equity found in the balance sheet.

Investment guru, Warren Buffet, believes that the return a company gets on its equity is one of the most important factors in making successful stock investments. What prompts him to say so is because a higher return on equity means that surplus funds can be invested to improve business operations without the owners of the business (stockholders) having to invest more capital which further means that there is less need to borrow.

A low Return on Equity (RoE) means that the company has not used the capital invested by the shareholders efficiently, which reflects that the company is not in a position to provide investors with substantial returns. Moreover, a lower Return on Equity (RoE) might also indicate that the company has huge burden of debt.

How is Return on Equity important for investors

 

The Return on Equity (RoE) is further clarified in this article:

a) What is Return on Equity (RoE)?

Return on Equity (RoE) is a financial ratio that calculates the amount of net profit earned as a percentage of shareholders’ equity. It reveals how well the company has utilized shareholders’ money. Return on Equity (RoE)  is computed as net profit divided by networth (i.e. equity + reserves + retained earnings)

b) What is said to be the perfect Return on Equity (RoE)?

There is nothing called perfect Return on Equity (RoE). A Return on Equity (RoE) which is lesser today might increase in the long-run and therefore it depends upon the investor where to invest and when to invest.

However, experts believe that if a Company’s Return on Equity (RoE) is less than 14%, it is not good. A Company having negative Return on Equity (RoE) should never be invested in, particularly when the market is volatile. A negative Return on Equity (RoE) indicates that the Company is under excessive debt burden and thus they should be avoided. Any company with a Return on Equity (RoE) of 20% or more is considered by the experts. They feel that investors can invest their money in such companies for better return.

c) How is Return on Equity (RoE) related to valuations?

Return on Equity (RoE) impacts the valuation of stocks. If Return on Equity (RoE) is higher, the intrinsic value of the company will also be higher; this in turn will increase the valuation of a company.

d) Why is Return on Equity (RoE) important for gauging investment appetite?

The Return on Equity (RoE) of Indian companies’ has plunged in last 10 years. The plunge has been noticed in mostly all the sectors un-harming few companies. During such situation when all the sectors seem to fall, it becomes easy for investors to gauge the potential of a company by calculating the Return on Equity (RoE) and helps them to invest.

e) Why is it necessary to study Return on Capital Employed (RoCE) along with Return on Equity (RoE)?

Return on Capital Employed (RoCE) is a financial ratio that measures a company’s profitability and the efficiency with which its capital is employed. It is calculated as Earnings before Interest and Tax (EBIT) divided by Capital Employed

While analyzing a company, it has to be noticed that if a company has little debt it will be prudent to analyse the company using the Return on Equity (RoE) method. And in case a company has higher debt, it should be analysed using the Return on Capital Employed (RoCE) method.

Conclusion:

The above write-up explains the concept and makes it clear that from an investor point-of-view it is important that the investor understands which company to invest in, when to invest, and how to invest. Return on Equity is one such very important tool for measuring the performance index of a company. Ultimately it is the aim of every investor to invest in a company and come out of it making profit. The Return on Equity (RoE) is thus helpful for the investors in measuring the performance of a company and decide if it is worth investing in the company at a certain point of time.