Why Is 'Return on equity' - RoE very Important?

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Why Is 'Return on equity' - RoE very Important?

Indian companies return on equity (RoE) has halved from its 2005 highs to 12.3%, said Credit Suisse.

Here is why ROE is important for investors.

1. What is 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 efficiently a company has used shareholders' money .

RoE is computed as net profit divided by networth (i.e. equity + reserves + retained earnings)

2. How does RoE reflect corporate performance?

When a company has a low RoE, it means that the company has not used the capital invested by shareholders efficiently.

It reflects that the company is not in a position to provide investors with substantial re turns.

Analysts feel if a company's RoE is less than 12-14%, it is not sat isfactory. Companies with RoE of 20% and above are considered good investments.

Analysts caution inves tors not to consider companies that have a nega tive RoE, especially in this volatile environment.

They feel it is better to avoid these companies as they often are ridden with problems of excessive debt.

3. What is the use of RoE in stock market valuations?

RoE directly impacts stock val uations -higher the ROE, higher the intrinsic value of a company .

That explains why a lot of the companies with high RoEs have higher valuations.

4. Why is RoE relevant now?

Indian companies' return on equity has halved from its 2005 highs to 12.3%, said Credit Suisse.

Credit Suisse said the slide in RoE has been broad-based and not specific to sectors such as energy and materials on account of the fall in commodity prices.

RoE was one of the key parameters used by analysts to highlight the Indian corporate growth story between 2003 and 2007, which was may be showing signs of improving.

Indian companies' RoE hit a peak of 23.4% in 2005.Although RoEs have fallen in all major markets over the past few years on weaker global growth, a contraction in India has been among the most severe.

5. What is an alternative to ROE?

Return on Capital Employed (RoCE) is an alternative profit ability performance measure. It is a financial ratio which measures a company's overall profitability (both of debt & equity holders) and indicates the efficiency with which its capital (again both equity and debt) is employed.

“A company with high debt should be analysed using RoCE whereas a company with little debt should be analysed using ROE,“ said Vivek Mahajan, head of research at Aditya Birla Money.

Src: ET, Dia Rekhi

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