Return on equity
Also called: ROE
A year's profit divided by shareholders' equity: the rate at which a business grows its owners' money.
ROE tells you how hard the owners’ money is working. A company with a 20 percent ROE that keeps its profit could, in principle, grow its book value 20 percent a year without raising new capital. In India an ROE above 15 percent held for many years is a good sign, and above 25 percent for a decade is rare.
ROE has one big blind spot: debt. Borrowing adds assets without adding equity, so a company can lift its ROE simply by borrowing more. Screeners split ROE into profit margin, asset turnover and leverage (the DuPont breakdown) so you can see where it comes from.
Example
A company earns a profit of 300 crore rupees on shareholders’ equity of 1,500 crore. Its ROE is 20 percent.
Watch out
Two companies with the same 20 percent ROE can be very different animals. One earns it with fat margins; the other borrows five rupees for every rupee of equity. Look at the debt before you admire the number.
Learn it properly in
Chapter 1.2: P/E, P/B and ROE: three ratios that do most of the work