Nestle India commands the numero uno position among Nifty index stocks when it comes to return on equity (ROE). Nestle India’s ROE stands at 102.9 per cent.
Britannia Industries, and Information Technology major TCS stand at number two and number three positions with ROE of 60 per cent and 43 per cent, respectively.
So, do companies with higher ROE have something to boast about? The answer is yes. All the above mentioned companies are the darling of investors and the market. However, higher ROE alone should not be the reason to invest in a share.
ROE is one of the key factors that investors should look for while investing in a company’s share. It is calculated by dividing the net income of the company by the equity of its shareholders. This factor gives you an information about the company’s ability to generate high profits. A high ROE ratio means that the company’s management is efficient in generating profits. Similarly, a low ROE means that the stock is not able to generate high profits.
How To Calculate ROE
Take the net income of the company, the income generated by a company during a fiscal quarter, or year. Then, subtract the expenses, dividends and taxes to get the net income of the company, and then divide it by the total equity of the shareholders.
Suppose, the net income of a company is Rs 1 lakh in Q1FY23, and the shareholder’s equity in that quarter is Rs 3 lakh, so, the ROE ratio is 0.33. To get the ROE percentage, multiply it by 100, and we get 33 per cent as the ROE of the company.
How To Gauge ROE
ROE can be used to pick high profit-generating stocks within a sector or an industry.
Let’s take the sugar industry for example. The highest market capitalisation is of Balrampur Chinni Mills, and the stock’s ROE is 17.27 per cent. It is up by 5.99 per cent in the last six months. Now, the company with the second highest market cap, Triveni Engineering and Industries’ has its ROE at 24.78 per cent, and the stock has gone up by 19.53 per cent.
Points To Remember
If a company's equity investment falls, its returns rise, but this does not imply increased profitability. Similarly, a firm that has high debt will have high ROE, but this is not desirable.
So, while keeping ROE in the account, also consider the equity and debt of a company before investing.
A company with high debt cannot be differentiated solely on the basis of ROE. If the management is effectively using its funds to expand the business, then a company that is drowning in debt, might have a similar ROE. That’s why it is important to look at how the company is utilising debt.
Also note that ROE doesn’t take into account intangible assets like trademark, brand value, patents, copyrights, and goodwill of the company. These factors also contribute to the valuation of the company, while there is no way of including these in ROE.
In case a company’s ROE is negative, it signifies that it had a loss during the quarter or the fiscal year. This means that the company’s stockholders are losing money on their investments. A negative ROE is often to be expected for new and expanding businesses; but, if a negative ROE persists, it can be an indication of problems.
If the ROE is increasing, it can be a good sign, as it means that the profitability of the company is increasing. That said, it can also be artificially increased by reducing the amount of equity. A company can do this by taking in more debt, as equity is liabilities subtracted from assets. If the debt (liabilities) increases, then equity will decrease, and it will boost the ROE.