ROE in the Share Market – Everything You Need to Know!

ROE in the stock market refers to a financial metric or key indicator used by companies to assess their financial worth and return using the shareholders’ equity. It is a useful concept for companies that helps them in various ways. This blog provides everything you need to know about ROE in the stock market. It highlights what a high and low ROE reflects, why ROE matters, its key benefits and limitations, ROE analysis and calculation, and the key difference between ROE and ROCE. 

What is ROE in the Share Market?

ROE, or Return on Equity, represents a company’s performance and growth in a given period. To determine the ROI, a company usually assesses its profits or income after deducting all associated costs and divides them by shareholders’ equity in the company. 

ROE is a numerical percentage figure that keeps fluctuating with the market conditions. It is quite difficult to state an exact or ideal ROE for a company. For large companies, a 25% ROE is good. On the other hand, for small or medium-sized companies, a 10-15% ROE is desirable for growth and expansion purposes. 

ROE should never be too low, as it indicates that the company is struggling to pay its debts, is not earning sufficient profits, and has no or very low share value in the market. 

How to Calculate ROE?

To calculate ROE, a company needs to calculate its net income by eliminating or excluding all the expenses and associated costs from the total profit earned during a financial year, and the shareholders’ equity. After analysing both values, the company needs to divide the profits by shareholders’ equity at the end of the year to calculate its ROE. Let’s understand this with an example. 

Suppose a company earns a profit of 15 lakhs in a year, and the total expenses amount to 10 lakhs. The company’s shareholder equity amounts to 20 lakhs. Then, the ROI is:

Return on Equity =  (15,00,000 – 10,00,000) / 20,00,000 ✖ 100 = 25%

Benefits of Return on Equity

ROE serves different benefits to the companies. Some of them are as follows:

• 1. It is a major indicator that represents the company’s growth and performance.
• 2. It represents the sustainability and reliability of the company.
• 3. As it keeps fluctuating, a reduction in the percentage of ROI helps in understanding mistakes, risks, and areas of concern on time.
• 4. It serves an important purpose of the company: highlighting the dividend growth.

Limitations of Return on Equity 

In stock market trading there are certain limitations, or we can say precautions, that companies should take with ROE. Some of them are:

• 1. There should be a balance in financing options of the company, i.e., debt and equity. If the company prefers more debt over equity for financing its capital needs and greater ROE, it can lead to difficulties and operational inefficiency.
• 2. Different companies have different ROEs. Making a comparison between different companies’ ROE can be misleading and harmful.
• 3. ROE can be increased by manipulating the company’s books of account. There is always an uncertain risk for the shareholders.
• 4. ROE does not consider the company’s debt obligations or assets, so, not completely reliable for assessing the company’s financial health.

Return on Equity Analysis

Analysis of ROE is a method by which a company computes and calculates the ROE ratio to make a blueprint of the financial plan and smooth working of the company. Analysis of ROE usually involves the following steps:

• 1. Compute the company’s return on equity for the required financial year by using the formula: ROE = Company’s Net Income / Shareholders’ Equity X 100
• 2. Interpreting the result and analysing the total profit the company is expected to earn in the current or net financial years. 
• 3. Considering limitations, risks, and effective measures to mitigate them.

How to Analyse ROE for Stock Selection?

To analyse a good ROE for stock selection, you need to consider several factors like consistency in the company’s earnings, net profits, competitors, the company’s management, and associated risks. Here is how to analyse ROE for stock selection:

• 1. Compare different companies’ ROE and match them with your benchmark.
• 2. Check the company’s past years’ performance and consistency in maintaining the ROE.
• 3. Access the company’s financial performance, management performance and operational efficiency to assure a good and genuine ROE.
• 4. Be careful with extreme or very high ROE offering companies. There are possibilities that the company is using excessive debt financing to raise its return on equity.
• If you consider these few things, you can surely select a good company with a comparatively high ROE to invest your savings.

The Bottom Line 

ROE is not just a statistic or measure to analyse the company’s performance; it is an effective tool that highlights the company’s overall capabilities and efficiency. It signifies effective management performance, operational efficiency, debt obligations, expense management, and overall financial health of the company. A high ROE means a company is doing good in all key areas, while, on the contrary, a relatively low ROE reflects that the company’s performance in all key areas is failing sharply. Understanding the role of ROE is important for investors, shareholders, and companies alike for a better future. 

Frequently Asked Questions