Is Return On Equity A Company’s Financial Barometer?

Comparing a company’s return on equity (ROE) to its industry average or the ROE of similar companies can help investors determine whether the company is performing well or underperforming. Bhavya Rathod highlights how this can be used as an effective tool in the investment process 

“Return on equity is a huge determinant of corporate value.” This famous quote by legendary investor Warren Buffet rightfully indicates that return on equity (ROE) is a powerful financial ratio that helps investors gauge the profitability and efficiency of a company. It measures profitability by comparing a company’s net income to its shareholders’ equity. ROE is a critical metric for investors because it helps them evaluate how well a company is generating profits from the money that shareholders have invested in the business.
 

Significance of ROE

Joel Greenblatt, a hedge fund manager and author of ‘The Little Book That Beats the Market’, developed a formula for ranking stocks based on their ROE and earnings yield. Greenblatt believed that companies with high ROE and low valuations could outperform the market over time. High ROE is generally an indication of a profitable company that is efficiently utilising its resources, whereas low ROE may suggest that a company is not effectively utilising its shareholders’ equity to generate profits. [EasyDNNnews:PaidContentStart]

ROE is also used by investors to evaluate a company’s performance relative to its peers. Comparing a company’s ROE to its industry average or the ROE of similar companies can help investors determine whether the company is performing well or underperforming. Additionally, ROE can be used to compare companies in different industries and determine which ones are generating the most significant profits relative to their shareholders’ equity.
 

Calculation of ROE

ROE is calculated by dividing a company’s net income by its shareholders’ equity. The formula for ROE is as follows: 

Net Income is the company’s total earnings after deducting all expenses, including taxes, interest and depreciation. Shareholders’ equity is the total amount of money that shareholders have invested in the company. Shareholders’ equity is calculated by subtracting the company’s total liabilities from its total assets. The formula for shareholders’ equity is as follows:

The resulting ROE figure is expressed as a percentage. For example, if a company has a net income of ₹ 1,000,000 and shareholders’ equity of ₹ 5,000,000, its ROE would be 20 per cent.
 

Strengths of ROE

“The best companies are those with a high ROE over a period of years.” This quote by former manager of the Fidelity Magellan Fund, Peter Lynch, emphasises on ROE as an important metric for evaluating a company’s profitability. He believed that companies with high ROE were able to generate profits without relying on external financing, and therefore were able to grow their businesses faster. He preferred companies with ROE above 20 per cent and looked for consistent ROE over time. Lynch also believed that investors should look at a company’s ROE relative to its industry peers to get a sense of how well it is performing. 

ROE is a widely used metric by investors because of much strength. 

One of the most significant strengths of ROE is that it is a measure of profitability that takes into account the money that shareholders have invested in the company. By including the shareholders’ equity in the calculation, ROE provides a more accurate measure of how well a company is generating profits relative to the capital that investors have invested. Yet another strong point of ROE is that it is a simple and easy-to-understand metric that can be used to compare companies across different industries. ROE allows investors to quickly evaluate a company’s profitability without having to delve into the details of its financial statements. 

Additionally, ROE can be used to compare companies of different sizes, making it a useful tool for investors who are looking to invest in small or large companies. ROE is also useful for identifying trends in a company’s profitability over time. By calculating ROE for multiple years, investors can identify whether a company’s profitability is improving or declining. If a company’s ROE is consistently increasing, it may be an indication that the company is becoming more profitable and efficiently utilising its resources. Conversely, if a company’s ROE is consistently declining, it may suggest that the company is not effectively using its shareholders’ equity to generate profits.
 

Weaknesses of ROE

“We don’t really believe in just taking the return on equity and saying that’s the best investment. It’s just not that simple.” Charlie Munger, Vice Chairman, Berkshire Hathaway believes that ROE can be misleading because it does not take into account a company’s debt levels. If a company has a high level of debt, it may appear to have a high ROE, but its earnings may be going toward servicing that debt rather than generating profits for shareholders. Munger also believes that the quality of a company’s earnings is important to consider as some companies may have high ROE due to accounting tricks or other financial engineering rather than genuine earnings’ growth. 

Despite its strengths ROE also has some weaknesses that investors should be aware of. One of the most significant weaknesses of ROE is that it can be affected by factors that are outside a company’s control. For example, changes in interest rates or economic conditions can impact a company’s profitability and, therefore, the ROE. Additionally, ROE can be influenced by accounting practices, such as depreciation and inventory valuation, which can vary between companies and distort the accuracy of ROE comparisons. Another weakness of ROE is that it does not provide insight into a company’s overall financial health or its ability to repay its debts. 

A company may have a high ROE, but if it has a significant amount of debt it may not be able to meet its financial obligations. In this case, the company’s ROE may be artificially inflated and investors may be misled into believing that the company is more financially sound than it actually is. ROE can also be affected by stock buybacks or share issuances. When a company buys back its own shares, it reduces the number of outstanding shares, which increases the value of the remaining shares and can artificially inflate the ROE. Conversely, when a company issues new shares, it dilutes the value of existing shares and can reduce the ROE. 

According to Saurabh Mukherjea, the founder of Marcellus Investment Managers and a well-known Indian equity strategist, ROE should be used in conjunction with other financial metrics such as debt-to-equity ratio, free cash flow and valuation ratios to gain a comprehensive understanding of a company’s financial health. He believes that focusing too much on ROE without considering other factors can lead to an incomplete analysis of a company’s financial performance and may result in poor investment decisions. Moreover, Mukherjea has warned that a high ROE alone does not necessarily indicate a good investment opportunity. Investors must also consider the company’s industry, competitive landscape, management quality and other factors before making any investment decisions.

Looking at the table of BSE 500 companies with the highest average ROE over a period of 5 years, we can see that Tata Communications has the highest average ROE of 283.37 per cent, followed by CG Power and Industrial Solutions with 212.24 per cent. In terms of returns, Coal India has the highest 1-year return of 21.81 per cent, while CG Power, Industrial Solutions has the highest 3-year return of 3746.88 per cent and HLE Glascoat has the highest 5-year return of 1706.8 per cent. It is also interesting to note that some of the companies such as Graphite India and HEG Ltd., have negative returns over the 1-year, 3-year, and 5-year periods. This suggests that high ROE alone is not a sufficient indicator of good investment opportunities and that other factors such as market conditions and industry trends should also be considered. 

Looking at the table of BSE 500 companies with the lowest average ROE over a period of 5 years, we can also observe that the 1-year returns, 3-year returns, and 5-year returns of these companies vary significantly. For instance, Poonawalla Fincorp Ltd. and Tata Investment Corporation Ltd. have had impressive 3-year and 5-year returns. On the other hand, companies such as Graphite India Ltd. and Intellect Design Arena Ltd. have had negative returns over the same periods. This underlines the fact that even with low ROE, companies have given good investment opportunities to their shareholders, and therefore, ROE is not a significant indicator of better investment performance over a period of time.


 

Predicting ROE

Predicting future ROE is essential for making informed investment decisions. By predicting a company’s future ROE, investors and analysts can estimate the potential return on their investment and make strategic decisions on whether to buy, hold or sell the company’s stocks. Accurately predicting ROE can also help companies understand their financial performance and make informed decisions on how to improve their profitability and competitiveness. There are several methods that investors and analysts use to forecast ROE. Some of the most common methods are outlined herewith.
 

Regression Model

A regression model is a statistical technique that is commonly used to predict ROE. It involves identifying a set of variables that may be related to a company’s ROE and using them to build a mathematical model that can predict future ROE based on historical data. The regression model works by identifying the relationship between the independent variables and the dependent variable, which in this case is ROE. The independent variables can be a range of financial metrics such as revenue, net income, asset turnover, leverage ratio and other performance indicators that may impact ROE. 

The regression model uses historical data to identify the relationship between the independent variables and ROE, and then extrapolates that relationship to make predictions about future ROE based on assumptions about the future values of the independent variables. It is important to note that the accuracy of the regression model depends on the quality and relevance of the data used to build the model. If the variables used in the model do not accurately reflect the company’s performance, the model’s predictions may not be reliable. It is also important to consider other factors that may impact ROE, such as changes in the industry, regulatory environment or macroeconomic factors that may affect the company’s financial performance.
 

Financial Modelling

Financial modelling is a more complex method for predicting ROE, but it can be highly effective if done correctly. This method involves building a financial model that takes into account a range of variables, including revenue growth, profit margins and capital expenditures. By using this model, investors can forecast a company’s future ROE based on a range of assumptions about its future performance. Financial modelling can be a useful tool for predicting ROE, especially for companies that are experiencing significant changes in their business model or industry dynamics. However, financial models are only as good as the assumptions that are used, and if the assumptions are incorrect, the forecasted ROE may not be accurate.
 

Historical Trends

One of the most common methods for predicting ROE is to look at a company’s historical performance. This method involves analysing a company’s past ROE to identify trends and patterns that can help investors make informed predictions about future performance. Historical trends can be a useful tool, especially if a company has a consistent track record of performance. For example, if a company has achieved a high ROE over the past few years, it is likely that it will continue to perform well in the future. On the other hand, if a company’s ROE has been declining over the past few years, it may be a sign that its profitability is weakening. However, past performance does not always indicate future performance, and it is important to consider other factors that may affect a company’s future performance.
 

"Return on equity is a huge determinant of corporate value."

This famous quote by legendary investor Warren Buffet 


 

"The secret to investing is to figure out the value of something – and then pay a lot less."

-Joel Greenblatt
 

Industry Comparisons

Another method for predicting ROE is to compare a company’s performance to its industry peers. This method involves analysing the ROE of companies within the same industry to identify trends and benchmarks that can help investors make informed predictions about future performance. Industry comparisons can be a useful tool, especially if a company operates in a competitive market. For example, if a company’s ROE is consistently higher than its competitors, it may be a sign that it has a competitive advantage and is likely to continue to perform well. However, industry comparisons can be misleading if the company operates in a niche market or has unique competitive advantages that are not reflected in the industry averages.
 

Conclusion

One of the primary benefits of ROE is that it is a simple and easy-to-understand metric. Unlike other financial ratios that may require more complex calculations or a deep understanding of accounting principles, ROE can be easily calculated using publicly available financial statements. This makes ROE a valuable tool for both individual and institutional investors who may not have the resources or expertise to perform more in-depth financial analysis. When using ROE to evaluate a company, investors should be aware of the limitations of the metric. As previously mentioned, ROE can be influenced by accounting practices, external factors and stock buybacks or share issuances. Additionally, investors should be aware of industry-specific factors that may affect a company’s ROE. 

For example, companies in the technology industry may have higher ROEs due to their lower capital requirements and higher profit margins, while companies in the manufacturing industry may have lower ROEs due to their higher capital requirements and lower profit margins. To overcome these limitations, investors should use ROE in conjunction with other financial metrics such as the debt-to-equity ratio, price-to-earnings ratio and earnings per share. These metrics can provide additional insight into a company’s financial health and help investors make informed investment decisions. 

In conclusion, by understanding the strengths and weaknesses of ROE and using it appropriately, investors can gain a competitive edge in the stock market and achieve their investment goals.

[EasyDNNnews:PaidContentEnd] [EasyDNNnews:UnPaidContentStart]

[EasyDNNnews:UnPaidContentEnd]