Before heading with the main topic, let's understand this financial ratio or indicator 'Return on Equity or RoE'.
So, here's decoded all about RoE:
What is Return on equity?
Return on equity is by and large a ratio that calculates the rate of return that the shareholders or common stock owners' of the company get on their shareholding. Primarily, the ratio is suggestive of the fact as to whether or not the company generates decent returns on the investment it secures from its shareholders.
Calculation of Return on equity or RoE
Formula for Return on equity = 100%* (net income or profits/ shareholder's or total equity); herein the denominator or shareholder's equity implies the difference between the company's total assets and liabilities. Also, in a case when the company at any given point decides to clear its outstanding liabilities then the shareholder's equity would amount to whatever is remaining. This is perhaps the book value of the firm.
Simply stating it is computed by dividing the company's net income extracted from the latest income statement by the total equity at the end of the period.
There is also an alternate method to compute RoE, wherein average total equity is made use of and this is the average equity value between the starting and the year end.
Illustration to understand the calculation of RoE
Say for an instant company's ‘X' latest net income is Rs 1000 crores and their total equity is Rs 15,000 crores. Using the formula, RoE of company ‘X' comes to be as below:
= 100% * (Rs. 1000 crore/ Rs. 15000 crore) = 6.66%.
Interpretation of RoE:
The RoE of Rs. 1 for a firm means that Rs. 1 of common shareholding shall generate net income of Rs. 1
Importance of RoE for investors/Shareholders in the firm
This metric of Return on equity (RoE) is highly important for shareholders as it enables them to analyze the degree of efficiency with which a company is able to use or employ their invested corpus to generate additional revenues.
How to use RoE to make better stock selection?
Importantly, here you need to understand that RoE- the parameter can be used to pick stocks within the same sector only. This is because there can be huge gap in net income or profits across sectors. Also, within a sector, the RoE levels may be different. This is when a specific company in that sector may go in for dividend distribution and may not prefer to keep the profits as idle cash.
From this, we infer that RoE varies across sectors, say for instance a normal RoE in utility sector could be 10 percent or even less. Likewise, for retail or technology enterprise, normal RoE could be 18% or more.
So, as a thumb rule, you can pick stocks based on RoE by selecting or targeting a stock with RoE equal to or just above the average for the peer group.
Another important point that cannot be overlooked and needs to be mentioned is that RoE is even more important than Return on investment as it tells shareholders how efficiently their capital is being reinvested for generating returns. In a usual case, higher the return on equity better or more is the company's capacity to generate cash. So, higher return on equity points to a better standing of the company with respect to its capacity to yield returns for its shareholders.
List of 16 companies with RoE more than 30 percent
|Company name||RoE in %|
|02. Laurus Lab||45.15|
|03. Deepak Nitr||39.60|
|04. Page Ind||39.96|
|05. Tata Elxsi||30.15|
|06. Alkyl Amin||44.6|
|07. Clean Scie||45.00|
|10. Balaji Amin||31.38|
|11. Sonata Soft||31.08|
|12. Tatva Chint||36.85|
|14. Supreme Ind||30.65|
|16. Info Edge||42.84|
Market gurus have always recommended to invest in high RoE stocks. High RoE stocks have a capability or tendency to double investors' money in 3-4 years. The stocks listed above are the market leaders in their own industry and command highest range of RoE.