What is return on equity?

You wouldn't want a car with lousy mileage. So why should your stock investments be any different?

Return on equity (RoE) is essentially the mileage of a business. It is a percentage figure that helps you gauge how efficiently a company is capable of using your investments to generate profits - the higher the return on equity, the more efficient the company's management.

How is it calculated
You need to know two figures to calculate RoE - net income and shareholder's equity.

Net income is the total amount of money a business has earned in a given period after subtracting expenses, such as expenses it has incurred to run the business, interest payments on the loans it might have taken, taxes, amortisation, and depreciation. This figure is present at the end of a company's profit and loss statement.

Shareholders' equity represents the amount of money that will be returned to the shareholders if a company is liquidated, i.e., all its assets are sold, and debts are repaid. In simpler terms, it reflects the amount of money investors have invested. It can be calculated from the profit and loss statement by subtracting the company's liabilities from its assets.

Shareholders' equity = Assets - Liabilities

Once you know the net income and shareholders' equity, the return on equity formula is simple:

Return on equity (%) = (Net income/Shareholders' equity) X 100

How to use it
Suppose you are conflicted about which stock to buy: Company A or Company B. Both companies have recorded a net profit or net income of Rs 20 crore in a year, so the profit figure doesn't provide a clear choice.

The answer to this conundrum is simple. You open up their annual report, go to the profit and loss statement and calculate the RoE for each company.

Let's say
Shareholder equity of Company A = Rs 100 crore
Shareholder equity of Company B = Rs 200 crore

Thus,
RoE of company A (%) = (Rs 20 crore/ Rs 100 crore) X 100 = 20 %
RoE of company B (%) = (Rs 20 crore/ Rs 200 crore) X 100 = 10 %

Now, the choice is not left to debate. Company A with a higher RoE is more likely to manage your investment efficiently and give you better returns.

Drawbacks
While RoE is one of the most useful metrics for investors, it is not without its drawbacks.

• Sensitive to buybacks: The first drawback is evident from the return on equity formula itself. If the number of shares of a company decreases, shareholders' equity decreases. And as shareholders' equity is in the denominator, the RoE increases. Thus, if a company executes a buyback, where it repurchases shares from its shareholders, its RoE will rise and give a false impression that the management has suddenly become more efficient.
• It doesn't reflect debt: If a company increases its earnings using debt, it can easily inflate the RoE. However, growth on the back of high debt is not a good indicator for any company.
• Prone to manipulation through accounting jugglery: Revenues and income reflected in a profit and loss statement can be manipulated using various accounting techniques, impacting the RoE. For instance, if a company chooses to show a longer life for assets, depreciation expense will decrease. This will increase the net income and, thereby, the RoE. However, this higher RoE won't be due to better efficiency on the management's part.

Suggested read: A low P/E doesn't mean a higher margin of safety