Return On Equity In The Stock Market

People invest in the Stock Market, expecting profit and high returns in the future. For that, investors need to undertake thorough research on the stocks of the company they want to invest in, check the company’s past performance as well as future prospects before putting their hard-earned money on it.

The Return on Equity (ROE) is one such tool used to determine the financial performance of the company based on the financial trends.

What Is Return On Equity (ROE)?

The ROE is a simple ratio of the total profit of a company and the equity of its shareholders. There are two major sources of the equity of shareholders.

The first source is the amount of money invested by a shareholder in the company. The second one is the retained earnings of the company accumulated through its operation over time.

So for every amount invested by shareholders, the ROE helps to understand the amount of profit generated by the company. This amount of profit is shown in percentage.

However, ROE does not take into consideration any special kind of investor; it represents the profit of the company earned from common shareholders.

How To Calculate Return On Equity (ROE)?

The Return on Equity (ROE) is calculated based on the Company’s Net Income and the Equity of the Shareholders, when both are in positive numbers.

The Net Income of the company is calculated based on the dividend paid before to the common shareholders and dividend paid after to special shareholders, plus the interest paid to lenders.

Whereas the Equity of the Shareholders is calculated by adding Equity from the onset of the period for every common shareholder.

Formula Of Return On Equity (ROE)

By using the following formula, you can calculate the ROE of the company:

Return on Equity = Net Income of the Company/ Equity of the Shareholders

But, you must remember, higher the ROE of the company, higher is the profit of the company. This is because companies do not issue shares on a regular basis; they tend to use the same resource. The only factor which changes is the Profit, depending on the revenue and costs of the company.

So if the ROE increases, this means that the company is generating more income by using the same number of equities. This means that the company is using its money in the right direction and efficiently. Thus giving you an idea about the future growth of the company.

Example To Understand ROE

Suppose the Net income of a company is Rs 5,000,000, and the average equity of the shareholders is Rs 20,000,000, then the ROE of the company would be:

ROE = Rs 5,000,000/ Rs 20,000,000

= 25% (as ROE is expressed in percentage)

There is no ideal ROE of a company. While for some companies 25% can be a good ROE, for other companies 15% can be a good ROI.

Again, lower ROE doesn’t always mean that the financial performance of the company is low. It can be due to recent machinery purchases or a host of other factors. In such cases, the decline in ROE is temporary.

So, investors need to consider these factors and gauge the performance of the company to determine the long-term ROE.