Role of 'return on equity' in stock investing

ROE
Return on equity is similar to return on investment. It could be an investment of any type. Suppose you invested INR 5,00,000 in a business and at the end of the year you generated a net profit of INR 1,00,000 (profit after all the expenses and taxes). So using the money of INR 5 lac you earned INR 1 lac in a year. So return on your investment will be 20% by the below-mentioned formula.

Return on Investment= Net Profit/Amount Invested * 100

Return on equity is used for stock listed companies who borrow money from the general public (later they are called as shareholders) by issuing shares to them. During the initial public offering (IPO) suppose the company issued 30 lac (30,00,000) shares of face value 10 each.

It means the company borrowed INR 3 crore from the general public who bought 30 lac shares of the company @ INR 10 per share. So the amount of 3cr (3000000 * 10) becomes the part of the shareholders funds and the retained earnings (or losses) is also added to this amount to get the total shareholders equity.

Let us consider that the company has just started operating and still there are no retained earnings. 3cr (as mentioned above) is the only amount that is with them which they borrowed from the general public after issuing 30 lac shares to them.

Now suppose the company generated a net profit (profit after tax and expenses) of INR 50 lac (50,00,000) by using the shareholders equity amount of INR 3cr (3,00,000,00) in the first year of its operation. So the return on equity becomes 16.66% by using the below formula.

Return on Equity= net profit/equity * 100 (50 lac/3cr * 100=16.66%)

Now let us see how the return on equity plays a big role in making investment decisions. Actually, the stock price can only rise if there is growth in sales and net profit on YOY (year on year) and QOQ (quarter on quarter) basis. Suppose the company issued shares and raised INR 3cr from initial public offering (IPO) and let us suppose the company generated a net profit of INR 50 lac in the first year of its operation. So, in the 2nd year, the shareholders equity has gone up to INR 3.5cr (from 3 cr.) after adding the retained earnings of 50 lac (0.5cr) to it.

Let us again assume that in the 2nd year the net profit is still the same (INR 50 lac) as it was in the first year of companys operations. In the 2nd year, as you can see, though the shareholders equity has gone up (the company has now more money to invest in their business) the company is still generating the same net profit. As said earlier the stock price wont go higher unless there is a certain growth in the net profit YOY.

Let us assume that in the 3rd year also the company generated the same net profit of INR 50 lac though in the 3rd year the shareholders equity has gone up to INR 4cr (from 3.5 cr.) after adding the retained earnings. So here what is happening is that though the companys reserve is growing YOY the company is unable to generate more profit from the increased reserves.

In other words, we can say that their return on equity is going down YOY (as shareholders equity (denominator) is rising but net profit (numerator) is still the same) which gives a warning signal that the company is not able to utilize their funds properly. What they should do is to re-invest their extra reserves to earn more each year and then only the stock price of the company will go higher.

You can check the past 10 years data (including return on equity) of any company by using the search box as mentioned on the top banner on this site. If in the data companys return on equity is going lower each year then its not a good sign to invest in that company because of the reason as mentioned above. If the company is able to maintain or increase its return on equity then it is a perfect green signal to buy the stock but other factors too need to be considered.

According to Warren Buffet, the company should at least generate a minimum of 15% return on equity and should maintain it for years to come. You can make use of our stock scanner to find all the stock listed companies in India that are generating return on equity greater than or equal to 15%.

Written by: Rajesh Bihani, the senior writer at sharemarkethow.com.

Disclaimer: All the information compiled and presented here on this site is based on our financial background knowledge, years of practical experience, and recent research. But still we are not legally authorized to recommend stocks and so the information should be taken as our personal views only.