Return on Equity (ROE) is like a tool that helps you answer these questions when you invest in a company. It indicates how effectively a company is utilising the funds where you and other investors have invested to generate profits. In this article, let's break down ROE step by step using examples and discuss what to watch out for.

What is Return on Equity (ROE)

ROE is a way to measure how good a company is at making money using the money that its owners, called shareholders, have given it. Think of shareholders as people who own a piece of the company because they bought its shares. The company takes their money and uses it to run the business, buy machines, open stores, hire people, and so on. ROE tells you how much profit the company makes for every rupee of the shareholder’s money.

Let’s use a simple example:

Suppose you give your friend ₹10000 to start a fruit stall. At the end of the year, the stall makes a profit of ₹2000 after paying all expenses (like buying fruits, paying rent, etc.). To find out how well your friend used your ₹10000, you divide the profit by the money you gave:

• Profit = ₹2000
• Money you gave = ₹10000
• ROE = ₹2000 ÷ ₹100 = 0.2 or 20%

This means for every ₹10000 you invested, your friend made ₹2000 in profit. That’s ROE in action! In the business world, ROE works the same way but with bigger numbers and more details.

Why Does ROE Matter

ROE is like a report card for a company. It shows how smartly the company is using the money it got from its owners. Here’s why it’s important:

Helps You Pick Good Companies: 

If you’re thinking about investing in a company (buying its shares), ROE tells you if the company is good at making profits. A higher ROE usually means the company is doing well.

Compare Companies: 

ROE compares two companies in the same industry. For example, if two companies sell clothes, the one with a higher ROE is probably better at turning money into profits.

Shows Management Skills: 

The people running the company (managers) are responsible for using shareholders’ money wisely. A good ROE means the managers are doing a great job.

Tracks Progress: 

By looking at a company’s ROE over many years, you can see if it’s getting better or worse at making profits.

Example: If a company’s ROE is 15% every year for five years, it’s probably a stable and reliable business. But if the ROE jumps up and down, it might be risky.

How Do You Calculate ROE?

Calculating ROE is simple once you know the two main numbers you need:

Profit After Tax (PAT): 

This is the money the company makes after paying all its expenses, taxes, and other costs. It’s the “net profit” left over.

Net Worth

This is the total money that shareholders have given to the company, plus any profits the company has kept over the years.

The formula for ROE is:

ROE = Profit After Tax (PAT) ÷ Net Worth

Let’s break it down with an example:

Suppose a company called Happy Sweets Ltd. makes a profit of ₹2,000 crore after paying taxes. The shareholders have given the company ₹15,000 crore in total (this is the net worth). To find the ROE:

• PAT = ₹2,000 crore
• Net Worth = ₹15,000 crore
• ROE = ₹2,000 ÷ ₹15,000 = 0.1333 or 13.33%

This means for every ₹100 of shareholders’ money, Happy Sweets Ltd. makes ₹13.33 in profit. Not bad!

Where Do You Find These Numbers?

If you want to calculate ROE yourself, you can find the numbers in a company’s financial statements, which are like its money report card. Here’s where to look:

Profit After Tax (PAT): 

Check the company’s income statement. This document shows how much money the company earned, spent, and kept as profit.

Net Worth: 

Look at the company’s balance sheet. Net worth is calculated as:

Net Worth = Equity Capital + Reserves and Surplus

Equity Capital is the money shareholders paid to buy shares.

Reserves and Surplus is the extra money the company saved from past profits.

These reports are usually available on the company’s website or stock exchange websites.

A Deeper Look: The DuPont Analysis

ROE sounds simple, but there’s a clever way to break it down to understand why a company has a high or low ROE. This is called DuPont Analysis, and it splits ROE into three parts to give you a clearer picture. Don’t worry, it’s easier than it sounds.

The DuPont formula is:

ROE = Net Profit Margin × Total Asset Turnover × Equity Multiplier

Let’s explain each part like you’re running a lemonade stand:

Net Profit Margin: 

This tells you how much profit you make from every rupee of sales. For example, if you sell ₹100 worth of lemonade and make ₹20 profit, your profit margin is ₹20 ÷ ₹100 = 20%. A higher margin means you’re good at keeping costs low.

Total Asset Turnover: 

This shows how well you use your stuff (like your lemonade stand, juicer, and tables) to make sales. It’s calculated as Sales ÷ Total Assets. If you have ₹50 worth of equipment and sell ₹100 worth of lemonade, your turnover is ₹100 ÷ ₹50 = 2. A higher number means you’re using your stuff efficiently.

Equity Multiplier: 

This measures how much the company relies on borrowed money (debt) compared to shareholders’ money. It’s calculated as Total Assets ÷ Net Worth. If you have ₹100 in assets and ₹50 in net worth, your multiplier is ₹100 ÷ ₹50 = 2. A higher number means the company borrows a lot, which can boost ROE but also makes it riskier.

When you multiply these three numbers, you get the ROE. This helps you see why a company’s ROE is high or low. For example:

• A company with a high profit margin (good at keeping costs low) will have a higher ROE.
• A company that uses its assets well (makes lots of sales with little equipment) will also have a higher ROE.
• A company that borrows money might have a high ROE, but it’s riskier because it has to pay interest on the loans.

Comparing Two Companies

Let’s look at two imaginary companies, Sunny Toys Ltd. and Happy Games Ltd., to see how ROE and DuPont Analysis work. Both companies make toys and are about the same size, but their ROE tells different stories.

Step 1: Calculate ROE

• Sunny Toys Ltd.
  • ROE = ₹2,400 ÷ ₹2,600 = 0.923 or 92.30%
• Happy Games Ltd.
  • ROE = ₹2,620 ÷ ₹5,000 = 0.524 or 52.40%

At first glance, Sunny Toys looks amazing because its ROE is much higher. But let’s use DuPont Analysis to dig deeper.

Step 2: DuPont Analysis

Let’s break down the ROE for both companies:

• Net Profit Margin:
  • Sunny Toys: ₹2,400 ÷ ₹12,000 = 0.2 or 20%
  • Happy Games: ₹2,620 ÷ ₹11,800 = 0.222 or 22%
  • Winner: Happy Games keeps more profit from each sale.
• Asset Turnover Ratio:
  • Sunny Toys: ₹12,000 ÷ ₹5,200 = 2.3
  • Happy Games: ₹11,800 ÷ ₹5,000 = 2.4
  • Winner: Happy Games uses its assets slightly better to make sales.
• Equity Multiplier:
  • Sunny Toys: ₹5,200 ÷ ₹2,600 = 2
  • Happy Games: ₹5,000 ÷ ₹5,000 = 1
  • Winner: Sunny Toys, because it uses debt to boost its ROE.

Step 3: What Does This Mean?

• Sunny Toys has a much higher ROE (92.30%) because it borrows money (has ₹2,600 crore in debt). This makes its equity multiplier higher, which boosts ROE.
• Happy Games has no debt, so its equity multiplier is 1. Its ROE is lower (52.40%), but it’s safer because it doesn’t have to pay interest on loans.
• Happy Games is actually better at making profits from sales (higher profit margin) and using its assets (higher turnover), but Sunny Toys’ debt makes its ROE look better.

Step 4: Which Company is Better?

Sunny Toys looks more profitable because of its high ROE, but it’s riskier. If it can’t pay the interest on its ₹2,600 crore debt, it could get into trouble. Happy Games is safer because it doesn’t borrow money, but its ROE is lower. If you’re an investor, you might prefer Happy Games for safety or Sunny Toys if you’re okay with some risk for a higher return.

Why Is ROE Useful?

ROE is like a flashlight that helps you see how healthy a company is. Here’s why it’s so helpful:

Find Strong Companies: 

A company with a high ROE (15%–20% for many years) is usually successful at making money for its shareholders.

Track Performance Over Time: 

If a company’s ROE is steady or growing over 5–7 years, it’s probably well-managed. For example, if Happy Sweets Ltd. had an ROE of 10% five years ago and now it’s 15%, the managers are doing something right!

Spot Multibagger Stocks: 

A “multi-bagger” is a company whose share price grows significantly over time. Companies with high and steady ROE are often multi-baggers because they continue to make profits year after year.

Compare Competitors: 

ROE helps you pick the best company in an industry. For example, if two phone companies have ROE of 10% and 20%, the one with 20% is probably better at using shareholders’ money.

Limitations of ROE

ROE is super helpful, but it’s not perfect. Here are some things to be careful about:

Can’t Compare Different Industries: ROE works best when comparing companies in the same business. For example, a tech company might have a high ROE because it doesn’t need much equipment, while a factory might have a lower ROE because it needs expensive machines. Comparing their ROE wouldn’t make sense.

New Companies Can Look Better: A new company might have a high ROE because it’s still building up and has less net worth. But that doesn’t mean it’s better than an established company.

Tricks with Numbers: Some companies play with their financial reports to make ROE look better. For example, they might lower depreciation  or stretch out project timelines to show higher profits.

Debt Can Fool You: A company that borrows a lot might have a high ROE, but it’s riskier. If it can’t pay its loans, shareholders could lose money. Sunny Toys from our example is a good case its high ROE comes from debt, which makes it riskier than Happy Games.

Tips for Using ROE Wisely

If you’re thinking about investing in a company, here’s how to use ROE smartly:

Look for Consistency: A company with an ROE of 15%–20% for 5–7 years is usually a good bet. Avoid companies with ROE that jump around a lot.

Check the Industry: Compare a company’s ROE to others in the same business. A 10% ROE might be great for a bank but terrible for a tech company.

Watch Out for Debt: Use DuPont Analysis to see if a high ROE comes from borrowing. If the equity multiplier is high, the company might be risky.

Combine with Other Tools: ROE is just one number. Look at other things like profit growth, debt levels, and how the company is managed before investing.

Conclusion

Return on Equity (ROE) is like a magic number that tells you how well a company uses its owners’ money to make profits. It’s calculated by dividing Profit After Tax by Net Worth, and it helps you pick good companies, compare competitors, and track performance. The DuPont Analysis breaks ROE into three parts: 1) profit margin, 2) asset turnover, and 3) equity multiplier to show why a company’s ROE is high or low.

But ROE isn’t perfect. It works best for comparing companies in the same industry, and you need to watch out for tricks or high debt that can make ROE look better than it really is. By using ROE wisely, along with other information, you can make smarter decisions about where to invest your money.

Think of ROE like checking the health of a tree. A high ROE means the tree is growing strong and bearing lots of fruit. But you still need to check the roots (debt) and soil (industry) to make sure it’s a good tree to invest in.