Return on Equity Ratio indicates the profitability of a company. It evaluates the profit-making scenario by using shareholders’ equity. ROE interprets how much profit a company generates by using each rupee from shareholders’ equity. Although the ratio doesn’t necessarily reveal the entire financial movements of a company, it certainly helps investors to evaluate a company’s value and growth to some extent.
ROE calculation consists of two main points: net income or profit of a company and shareholders’ equity. Here net income means the profit of a company for a fiscal year. In order to calculate ROE net income is to be divided by shareholders’ equity. The formula of return on equity ratio is as follows:
Here net income indicates profit after tax for one fiscal year. Basically, the ratio shows how much profit a company can generate form each shareholders’ equity.
Why Return on Equity Ratio Is Important?
- ROE ratio interprets how efficiently a company uses shareholders’ money to generate maximum profit.
- Generally, it helps fundamental analysts to find profitable stocks.
- The higher the ROE ratio, the more efficient the company is for using shareholders’ equity
- Investors would like to prefer the high return on equity ratio of a company for a profitable return.
In this context, one thing is quite important that the comparison of return on equity ratio should be done within the same industries.
Return on Equity effects
Positive ROE: It interprets company is well organized at generating shareholders’ return. It indicates how wisely a company can invest the amount and increase the productivity and profit. It shows the company can generate more assets to cover its liabilities. Therefore, undoubtedly it is a safe investment choice.
Negative ROE: In contrast, a decreasing ROE means the company is making a poor decision and their equity management efficiency is not good at all. So it is clear that a company with negative ROE has more debt and not a safe investment choice.
Return on Equity Ratio Rates
As I mentioned lower ROE ratio is not good for investing, so investors generally prefer a company with high ROE ratio. There is a certain scale by which one can measure the high and low ROE ratio. Generally, minimum 15% ROE indicates better valuation and profitable stock and below 10% ROE considers as poor rates for a company.
This chart shows ROE rates more than 15%. So, according to the chart 33.23 rates consider more profitable. One of the most important point regarding ROE ratio analysis is an average of 5 to 10 years ROE ratio give a better picture of the growth of a company.
However relying solely on ROE for investment is not safe but this indicator is certainly an important tool in terms of investment.