The Return on Equity ratio measures the rate of return that the stock holders of common stocks of a company enjoy on shareholdings. Return on equity depicts how good the company is in terms of generating returns on the investment.
Return on equity formula:
Mathematically, Return on Equity is calculated as shown below:
Return on equity = Net Income or Profits
The denominator in return on equity formula is necessarily the difference between company’s assets and liabilities. It is the sum remaining after the company decides to clear off its liabilities at a given time.
For example, if a company has a return on equity of 1, it means that Re 1 of common shareholding generates a net income of Re 1. This metric is extremely important from the investors’ point of view, as this is used to judge a company’s ability to utilize the investment to generate revenues.
Investors tend to invest in those firms that have higher return on equity. However, this metric can be considered as a standard to invest in companies of the same sector. Profits and revenues generated vary significantly across sectors. In companies of the same sector, the return on equity varies, if a company decides to distribute dividends to the investors, instead of retaining the generated profits called retained earnings.
Suppose, a company ABC has generated a profit of Rs 2,00,000 and had issued 500 shares each at Rs 100 to stockholders. If the company decides to distribute dividends worth Rs 20,000 to the shareholders, then the return on equity is calculated as below:
Return on equity = (2,00,000-20,000) / (500*100) = 3.6
This means that for every one rupee invested in the company ABC, investors get Rs 3.6. In general, 3.6 is a high value. This implies that the company ABC was started recently and is a fast-growing company.
Denominator in the return on equity formula, average stockholder's equity, can be found in the company's balance sheet. Stockholder's equity is a company's assets minus liabilities. When calculating return on equity, the stockholder's equity must be averaged on the basis of time.
For example, if an investor is evaluating the return on equity for the year 2020, then the starting and last stockholder's equity must be accounted. Stockholder's equity is also called net assets. A formula to calculate return on equity is as shown below:
Return on average equity = Net income/Average share holder’s equity.
A negative return happens when a company undergoes financial losses or lackluster returns on investments over a specific time period. In other words, the company loses more money than it makes and thereby experiences a net loss. Few companies report negative returns in early stages.
This is because a considerable amount of capital, initially goes towards the business. Spending a lot of money received as investment while not generating revenues leads to loss.
Generally, new companies make profits after a few years from their establishments. A negative return is also referred to as negative return on equity. If the price of the stock goes below the price at which you purchased, then it is considered negative return.
Leverage is basically the debt of a company. Investing in those companies with high leverage must be avoided. This is because the companies having high debt would utilize the investment to service the debt (pay interest) and thereby investors don’t get much return on investment. Investors must look at company’s debt to equity ratio before investing. The formula to calculate debt to equity ratio is total liabilities divided by total equity. The debt to equity ratio is financial leverage ratio. Financial leverage ratios are used to measure a company's capacity to handle long term and short term debt.
Debt to equity ratio = (total liabilities) / (shareholders equity)
Both debt and equity are found in company's balance sheet. Debt is shown as total liabilities and equity is shown as total stockholder's equity.
A company has two options if it wants to raise funds to make profits. A company can take on either debt or new equity. It is critical for a company to be utilizing investments efficiently, regardless of the source. The return on equity reflects only the results of a company's equity investments. This means that a company may be highly leveraged, but will still show ROE to be improving if the debt is able to generate income.
Following are the advantages of return on equity:
Following are the disadvantages of return on equity:
When companies write down, it reduces the shareholder's equity considerably without modifying the net income. Therefore, you would see a large jump in the return on equity even though nothing actually changed.
When a company buys back a large number of shares from the market, it’s going to reduce the shareholders equity considerably. When the company buys back, it’s going to improve the return on equity ratio. There’s no significant change in the way the company does business, but the return on equity improves considerably. This is one of the major reasons that return on equity has to be considered carefully.
Another big concern with return on equity is that it does not take into consideration the debt of a company. It considers only the net income and the shareholders equity. Therefore, a company may have massive amounts of debt and still look like it is handling debt well as per the return on equity calculation. Even if it shows a good ratio, it could be close to crumbling as it has more debt than what it actually can handle.
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