ROE Return on equity How to calculate? Let us see by the example
The ROE ratio is discussed for stock analysis or comparing the different companies of
the same sector or you can evaluate the performance of your own business.
What
is equity?
Equity
is nothing but the ownership of the company.
What is ROE?
The
shareholders invested their money in the company so how much they earn from
their investment in the company in a year is called Return on Equity.
There
are two types of equity.
1.
Return on total equity
2.
Return on common equity:
In this category, preference equity is not considered.
We
will see both the types here.
Return
on equity definitely tells about the earnings on the equity but there are
certain limitations also in return on equity. In the 2008 crises, many companies
have misguided to the shareholder. They have taken high debt to show high
returns on equity.
There
are two ways to raise the capital of investment.
1.
Equity
2.
Debt
Equity
can be raised in three ways
Equity
Share Capital: Initial Investment by promoters.
Reserves
& Surplus: Cash + Profit ( This maybe after a few years as the company grow
their business they will earn some profit and all profit will not be used or
distributed to shareholders but they keep theses money as a reserve.)
Preferred
Shares. This can be raised from friends and families or strategic partners by
creating confidence and promise that they will get some percentage of money on
their investment than the other common equity shareholders.
Let
us understand by example:
Suppose
company A has established with a capital of 3 crores. With the following details.
|
Initial Investment |
200L |
|
Reserve & surplus |
50L |
|
Preference shares equity @ 15% (promise
by the company as a dividend) |
50L |
|
Debt @ 10% interest rate |
300L |
|
EBIT (Earnings before Interest and Tax)(Operating
profit) |
100,00,000 (100L) |
|
Interest on Debt (-) |
30,00,000 (30L) |
|
PBT Profit before Tax |
70,00,000 (70L) |
|
Tax @ 30% (-) |
21,00,000 (21L) |
|
PAT (Profit after tax) (Net profit) |
49,00,000 (49L) |
In
the above example total equity is
Return
on common equity means return on initial investment+ Reserves & surplus
preferred equity i.e. 200+50 +50L = 300L
The
priority of payment will be
- 1. Debt
- 2.
Tax
- 3.
Preferred equity
- 4.
Common equity
Since
we have to calculate on returns on equity we have to consider PAT for the
calculation as the priority of payment is 1. Debt interest 2. Tax.
Since
we are calculating Return on Total Equity we will not consider 15% (in this
example) payment as it is a part of total equity.
So
Return on Equity = PAT/Total equity
In
this example PAT = 49 L. Total equity = 300L. Then ROE will be 49/300 = 16.33%.
For
calculating the return on common equity then the formula will be:
Return
of Common equity = PAT-Dividend on preferred equity/Common Equity.
= 49-(0.15*50L)/(200+50) = 41.5/250L = 16.6%.
So
the returns on common equity are on the higher side because here the preference equity the dividend has deducted from the PAT.
But
sometimes the company, rearrange or manipulate the ROE to lure the shareholders. As
investors are interested in returns from their investment in equity.
There
are two ways to increase the ROE either by increasing the efficiency of the
company which will in turn increase the profit of the company. But instead, they are applying another way of manipulation by reducing the total equity.
How
they can reduce the equity just by increasing the debt.so let us see by example
herewith. So by increasing the debt it really gives the benefit or disadvantage
let us see case by case.
|
Company -1 |
Company-2 |
|
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|
|
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Case-1: Both the companies are doing their
business efficiently
Let
us calculate ROE for both the companies:
Company
1: 49L/300L = 16.33%
Company
2: 38.5L/150L = 25.66%.
Why
Company-2 is giving more return on equity?
This
is just because it is doing business very efficiently.
Case-2: Bad economy
Company-1
Company-2
|
|
ROE for the company is negative and in fact its
equity is getting eroded due to high debt interest.
Conclusion: In excessive debt can demolish the company
in a tough economic environment. Hence ROE (Return of equity does not show a clear scenario
we have to see the ROCE (Return on capital employed.)
Hence one should not rely on one ratio but
one should study all fundamental analytical ratios before investing in the
stock.
How to carry out the comparisons between
two companies.
Let us see by the example:
|
|
ROE company1 = 49L/300L = 16.33%
ROE company2 = 63L/400L = 15.75%.
If we
observe the above calculation even company -2 is making a high profit (63L) and having less debt but ROE for
this company is lower compared to the ROE of company-1. This is because it has more
equity capital but it is not utilizing their capital efficiently even though it
has more resources than company-1.
So by
comparison company-1 is giving better ROE but one should not stop by just comparing
the ROE but he should also calculate other financial ratios as well. As we have
elaborated in a bad economy if the company is having high debt then the impact
will be adverse.
You
can compare or calculate ROE for any companies by observing the financial
statements of those companies which are easily available online website like WWW.Moneycontrol.com, WWW.IIFL.com. Also, the readymade ratios are
also available online.
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