Before we go into the details of how to calculate ROE, we must know its use.
Why ROE is one of the most valuable financial indicator for investors?
Over the years, investors have used Return on Equity (ROE) as their litmus test to value stocks.
ROE is one very effective tool to compare profitability of one company with other.
Using ROE one can compare profitability of two companies of different sectors.
Why it is important to compare apple to apple?
Lets take example of two Indian stocks ‘Wipro’ and ‘Eicher Motors’.
Wipro is a company which operates in IT sector.
Eicher Motor is a Automobile stock.
If one will see Net Profit Margin of these stocks, they will look like this:
- Wipro@ 18.29% PAT Margin.
- Eicher@ 17.75% PAT Margin.
Looking at PAT Margins it looks like shareholders will profit more from Wipro.
But the reality is different.
To evaluate shareholders returns best financial metric is ROE.
ROE of our example companies look like this:
- Wipro @25.16% ROE.
- Eicher @45.30% ROE.
Using this financial metric it is clear that, for per dollar of shareholders money, Eicher is generating more profit.
If we would have seen only PAT Margins, we would have considered Wipro as more profitable.
This would have been a big miss as Eicher Motors is having a much higher ROE.
Let us take another example -2
Reliance Industries (RIL) has PAT of Rs 21,900 crore.
While Bharat Forge has PAT of just Rs 400 crore.
For majority of us, Reliance Industries looks like a better investment over Bharat Forge, right?
But this conclusion may not be so correct.
How best we can compare these two companies?
Does the huge PAT confirm that Reliance Industries is better than Bharat Forge? The answer is no.
In order to evaluate companies, experts reply on metric like return on equity (ROE).
All investors would like to buy stocks of company which are more profitable.
When we check ROE of our example companies, they look like this:
- RIL @11.11% ROE.
- Bharat Forge @ 14.85% ROE.
In terms of shareholders profitability, Bharat Forge looks better placed.
How to calculate ROE – Formula:
If a company ABC makes $10 million in PAT.
ABC also has $25 million as Shareholders Equity
(Note: Equity Share Capital + Reserves = Net Worth = Shareholders Equity).
In this cash ROE of ABC would be: ROE = $10/ $25 = 40%.
What it means by Return of Equity (ROE) of 40%?
In isolation ROE of a company will mean nothing to investors.
But when we compare two companies ROE it will become an invaluable value indicator.
Lets come back to our example of Reliance Industries and Bharat Forge.
|Company||PAT (Rs. Crore)||Shareholders Equity (Rs. Crore)||ROE|
In terms of PAT, Bharat Forge is no match to RIL.
But in terms of ROE, Bharat Forge looks superior than RIL.
When a company registers a high ROE, it means it is using effectively funds of shareholders.
This makes companies management favorite of the shareholders.
More profit from per dollar of shareholders funds is what makes Bharat Forge so likeable.
Champion investor Warren Buffett has strong belief in ROE.
He says, companies which is sustaining high ROE year after year are good companies.
Over a period of time companies increase their sales turnover.
In an effort to increase turnover, ROE often gets compromised.
But companies which is able to grow turnover and still maintain ROE are exception companies.
Such companies must be identified and should be tracked.
Their stocks can be bought when they are trading at attractive price levels.
It is difficult for companies to maintain high ROE when their turnover increases.
High turnover means company require more operating capital.
When requirement of operating capital increases, companies takes more debt.
Higher debt means lesser PAT. High debt is not good even if it is helping to increase the turnover.
Debt leads to high expense in terms interest payment. It also makes the company risky.
In fact many of the largest and wealthiest U.S. companies like General Electric, Microsoft, Wal-Mart and Cisco Systems have sustained high ROE levels irrespective of their size.
These companies are able to maintain ROE of 30% or more.
One such exception company in Indian stock market is Tata Consultancy Services (TCS).
|TCS||Mar ’14||Mar ’13||Mar ’12||Mar ’11||Mar ’10|
So does it mean that if one knows how to calculate ROE, they need to check nothing to verify profitability?
In our comparison between Reliance Industries and Bharat Forge, we have to perform one more check.
ROE on its own is not a fool-proof tool to check profitability.
If Reliance Industries profitability (ROE) is less than Bharat Forge them why investors still buy RIL?
Rule of thumb says, company with high ROE should be preferred for investing.
But this is not happening in this case. RIL is a more preferred stock.
There must be something that we are missing. I got the answer when I looked at the companies Balance Sheet.
Bharat Forge is relying too much on Debt to finance its working capital.
Every company needs capital to do its business. Companies raise capital in two ways.
They can raise money from stock market (shareholders capital). They can also take debt from market (like banks etc).
When we calculate ROE, only shareholders capital is used to check profitability.
There can be examples where company’s capital structure is Low Equity + High Debt.
In this case ROE will be high as ROE = PAT/Equity.
ROE formula does not give us an idea about companies dependency on debt.
Investors avoid stocks of companies which carry excess debt even if its ROE is very good.
The solution is to check ROE and Debt Equity Ratio simultaneously.
High ROE and Low Debt Equity Ratio is a combination that investors likes to see.
Example: Very Good ROE but bad Debt/Equity Ratio
|Company name||ROE (%)||Debt/Equity (%)|
|GRUH Finance Ltd.||32.23||1,061.76|
|Hatsun Agro Product Ltd||52.88||275.11|
|Mahanagar Telephone Nigam Ltd||693.76||281.92|
This study gives us two important insights.
It is essential to invest in companies with high ROE.
It is also essential to check the debt/Equity levels of company.
If company is relying high on debt they are risky for investment.
Moreover, high debt means increased expense in profit & loss accounts.
High debt means higher interest payment.
This further reduces the PAT hence ROE.
Stock with High ROE & Low Debt/Equity Ratio
(Updated on April’2018)
- Tata Communications Ltd. – 200.3% ROE
- Castrol India Ltd. – 115.24% ROE
- Tata Metaliks Ltd. – 75.8% ROE
- Hindustan Unilever Ltd. – 67.8% ROE
- Eris Lifesciences Ltd – 57.63% ROE
- Colgate-Palmolive (India) Ltd. – 50.48% ROE
- Hatsun Agro Products Ltd. – 46.51% ROE
- 8K Miles Software Services Ltd. – 46.21% ROE
- Bajaj Corp Ltd. – 44.76% ROE
- Interglobe Aviation Ltd. – 44.55% ROE
Check this link to get a list of Top 50 Indian stocks having very high ROE ratio in a tabulated form…