I’m sure you must have tried investing in equity or shares. While some may be successful and majority of them don’t succeed. Making decent returns in equity markets is a matter of discipline, self-control, common sense and lot of patience.
Few parameters will help you get successful with stocks and RoE – Return on Equity is one such parameter which will help you choose better companies.
RoE is not the only parameter but it is one of the most important parameters for successful companies. Successful companies have good management which focus on RoE and this translates to good returns in equity markets.
There are two different ways to fund a business or a company viz. use of borrowed capital and/ or use of owned capital.
Use of owned capital simply means, that the owners themselves bring in equity into the business. The purpose of bringing in one’s own money/ equity into the business is to get maximum profits from it.
What is RoE – Return on Equity and how it affects investment returns
Return on Equity (RoE) is a helpful measure to find out the level of profits made on the owner’s equity. It shows how well or effectively the owner’s equity has been utilized.
It is expressed in terms of a percentage.In most businesses especially manufacturing & service related, High RoE indicates better profitability and long-term sustainability of the business and vice-versa.
You can learn how to calculate ROE from Investopedia article.
The above table shows a small increase in the Net Profits of Reliance Industries Ltd for the financial year ended 2014-15 over the previous financial year.
However, the Return on Equity shows a marginal decline over the same period. This clearly shows that even though the profits have increased, utilization of equity holder’s capital has gone down marginally.
This insight can be very useful for any existing or new investor of the company, particularly when the decline/ rise is big.
The owners/ shareholders may be interested to know the performance of their investments. RoE can help them decide whether to remain invested in a business, to increase their investments or to exit out of a business.
RoE is also useful while considering alternate investments within the same industry. All other things being equal, a higher RoE stock/ company will be a better investment than a lower RoE one.
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The above table shows RoE’s of two leading banking stocks viz. Axis Bank and ICICI Bank. It is quite clear from the given data that both the stocks show a year-on-year growth in their respective RoE’s.
However, the available data also seems to show that Axis Bank has made better utilization of it’s owner’s equity. It is important however to consider several other factors before one draws a final conclusion about which out of the two is better.
There is no exact number to indicate a good RoE. Although an RoE around 15% is seen as good, it can considerably vary between different industries.
Analyzing the RoE of a stock with the other stocks/ companies in the industry can be insightful in revealing the stocks relative performance.
It is not right to conclude that a high RoE industry stock is better than a low RoE industry stock. A low RoE stock that is capital-intensive will face less competition from new entrants compared to a high RoE stock that requires lesser capital investment.
The performance also has to be analyzed keeping in mind the performance of the overall economy. This is because RoE follow a cyclical pattern.
It may change with the changing business or economic cycles. Generally, RoE tends to be higher during an economic boom period. Likewise, it tends to go down during periods of economic downturn.
Consider the above table that shows RoE of two large Indian IT giants viz. TCS and Infosys. As mentioned earlier, comparison between companies within an industry can be done effectively using this tool.
Here, though there is a downward trend in both their figures, TCS has managed a much better utilization of its owner’s equity. Both TCS and Infosys are extremely cash-rich companies and are hence virtually debt-free.
Why high RoE and high debts are mostly investment traps
However, having huge debts in their respective books would have changed the scenario completely for both of them.
|Case of Jaypee Group: RoE of Jaypee Group showed an upward trend right from the year 2005 onwards. The RoE was in the range of 16-22% over 5 year period starting in 2005. As the company aimed at huge expansion it started to use greater proportion of debt to fund its expansion. The after effects of global economic recession combined with contraction of Indian economy took its toll on the company. The huge pile of debt became even bigger putting Jaypee Group in a big mess, which has taken years to clear and a solution is nowhere in sight.|
Though, a higher RoE is considered better as it indicates better performance, a high RoE may be the result of a high proportion of debt capital.
In such cases, looking at only RoE can give an erroneous picture of the profitability and sustainability of a company/ stock. RoE impacts the long-term sustainability of a company/ stock.
The owners of the company are interested either to retain or scale-up their investments depending on the company’s long-term prospects.
Learning : While a lower RoE will discourage owners/ equity shareholders from continuing to remain invested, a high RoE as a result of a high financial-leverage (high proportion of debt) will also disappoint investors.
Company that is not adequately capitalized may not be able to sustain for a long period of time. Its situation may gradually worsen leading to default on its debts.
As interest payment of the debt become due it will burden the company severely. Hence, a high financial-leverage situation is a tricky one and can lead a company to bankruptcy if the company does not have sufficient cash to repay its debt.
It is important for a company not to raise too much debt as it exposes the company to undue risk. In order for the business to sustain over a long period it is important that it is well capitalized.
Hence you’ll see that understanding RoE Return on Equity is very important for choosing good investments. We hope this article was helpful to you.
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