Understanding ROE, ROCE and Shareholder's Equity

Return on Equity (Return on Net worth)

Return on Equity (ROE), also called as Return on Net Worth, is one of the key financial ratios which indicates how well the management has been efficient in managing the company's assets. In my early days in the investing world, this is the ratio which confused me the most. Return on Equity is defined by the following formula


What is confusing in the above formula for beginners is the meaning of 'Shareholder's equity'. Shareholder's equity should not be confused with 'total value of all the equities, i.e. shares'. The later is called market capitalization of the company. Shareholder's equity is defined by

Shareholder's equity = Total Assets - Total Liability

In other words, Shareholder's equity is nothing but the amount of money that the company would be worth if it were to go bankrupt at this very moment. This is also called as book value.

How to calculate ROE?

In order to calculate ROE, Return on Equity, lookup any financial portal or the company's annual report for the following

1. EPS - the earning per share of the company.
2. Book Value - The book value of the company per share (i.e. shareholder's equity divided by the number of shares).

Then to calculate ROE you simply divide EPS by Book Value. ROE is typically expressed as a percentage (i.e. multiply by 100 and put a "%" sign).

Example of Return on Equity : Let us say a company earns Rs. 100 per share and the book value of the company is Rs. 300. Then the Return on equity is 33.3%.

Typical values of Return on Equity and what it means

As a general rule of thumb, you should be careful while investing in any company whose ROE is less than 10%. I personally prefer stocks which give a return on equity of at least 20% or more. Obviously return on equity is a direct measure of how well the company is generating cash with the amount of 'shareholder's money' it has. There is one more thing which ROE tells you and which most financial websites don't mention. ROE also tells you how easy it is for the company to profitably expand its business. For example, let us take a situation where the company does not have any debt. Then an ROE of 25% means that the company is producing Rs. 25 for every Rs. 100 of assets it has. Thus if the company were to expand its business, then for every Rs. 100 spent on expansion, it would earn Rs. 25, which is greater than the usual interest rates. If ROE is roughly the same as the bank interest rates, then it means that even if the company expands, it will take a long time for it to make its investments in expansion profitable.

Variations: Return on Average Equity

The Book Value of a company can significantly change during a given year. In these circumstances, one can calculate the average book value (average of the book value in the beginning of the year and at the end of the year) and use it to calculate ROE.

What ROE does not tell you

ROE, like any other financial ratio is very far from being perfect. For example, ROE does not tell you anything about the debt of the company. As explained before it does say something about the potential of the company to expand its business, but does not actually tell you anything about the possible or expected growth of the company. Nevertheless, ROE is a very basic ratio, and used in addition with few other indicators like topline growth and financial ratios like P/E, Debt/Equity and profit margins can give a reasonable good and quick overview of the company.

ROE versus ROCE

A related ratio to Return on Equity is Return on Capital Employed (ROCE) or also called by the name of Return on Capital Invested (ROCI). ROCE is defined to be

ROCE = Operating Profit / Capital Employed.

Operating Profit means profit before tax, depreciation, interest and exceptional items. While Capital Employed is the cash (& assets) that was actually used to do the business in that year. The formula for calculating Capital Employed is

Capital Employed = Total Assets - Current Liabilities

Note that Current Liabilities are those liabilities which the company has to meet immediately (in the coming year). ROCE can sometimes give a slightly accurate picture than ROE, but I have found that overall if you look at the values of ROE for the past 5 years, you get roughly the same picture of the company as you would get by looking at values of ROCE. Moreover, ROE is easier to calculate.

Related Posts on Financial concepts and Investment Basics Understanding the P/E Ratio Return on Equity (ROE), ROCE and Shareholder's Equity Consolidated results vs. Standalone Results. Topline Growth vs Bottomline Growth

Topline vs BottomLine Growth - what is a better indicator? Investment Basics)

Topline vs Bottom Line Growth

(Anticipated) Growth of a company is an extremely important parameter in deciding the valuation of the company's stock. When a company grows, there are however various parameters which 'grow' when a company 'grows'. Among the most important of these are

1. Growth of a company's sales - This is called as Topline Growth for the simple reason that in accounting the sales of a company are written on the first line 'top line'.
   
2. Growth of company's net profit - This is called as Bottomline Growth, for the simple reason that Net profit of a company is written at the bottom, after writing figures of sales, expenditures, revenues, interest, depreciation, tax, etc.
   

Topline vs bottomline - simple example

Topline growth, or growth in sales represents the potential for the business to grow. Bottomline growth or growth in net profit, however can be caused either by increase in sales, or decrease in expenditure/raw material or various combinations including exceptional items (i.e. items which are one-time expenditures/income). Let us take the example of a steel company. If its sales grow by 25%, then topline growth is 25%. It show that the demand for steel, the basic output of that company is growing by 25%. However, it could happen that at the same time, prices for raw material, in this case coal or iron ore also go up by 15%. Other factors remaining same, the increase in net profit will be much less than 25%.

What number to look at while analyzing a stock - topline or bototmline ?

As far as getting an idea of how the company is growing, i think it is a good idea to look at topline growth. Various factors which come into play while calculating bottomline growth (e.g. raw material costs, etc.) are also important, but in my experience i have found it very convenient to analyze them by looking at financial ratios like operating profit margins (or ebitda margins) or net profit margins.

Related Posts on Financial concepts and Investment Basics Understanding the P/E Ratio Return on Equity (ROE), ROCE and Shareholder's Equity Consolidated results vs. Standalone Results. Topline Growth vs Bottomline Growth

How to buy stocks in USA, China or overseas from India?

Indian Investors looking to invest in stock markets abroad

Have you been looking for investing opportunities beyond the Indian Stock markets (NSE, BSE)? For e.g. investing in Oil ETFs, or other mutual funds exclusively available in select developed countries like United States or Europe, UK, etc? Or thinking of buying stocks in China? Read on.. the answer to these questions is much simpler than what one would have imagined.

RBI allows $25000 foreign investment per annum

RBI has several restrictions on buying and selling rupee. For example, you are still not allowed to trade forex in india, unless it is for hedging purpose. However, fortunately, RBI has allowed every indian to invest up to $25000 overseas. This means you can use this much money to either buy real estate, stocks, mutual funds, or simply put that money in a savings account in USA, China or any other country (this last option does not make economical sense, because interest rates in India are higher). Thus trading in stocks in world markets either in USA, Japan, China, Europe, or any other country is now extremely Easy. All you do is start by registering with an online broker who allows you to trade in world markets of your choice.

Registering with an Online broker

An example of such an online broker is Interactive Brokers. This is just one example. There are several other online brokers which allow you to trade in world wide markets from India. Even ICICI Direct allows you to invest in stocks in USA or other countries. Google a little or keep your eye on advertisements. Good brokers usually advertise aggressively highlighting their plus points. The following things need to be kept in mind.

1. Trading in world markets may require a larger appetite. For example when you open an account with Interactive brokers, you have to start with $5000 for investing in world markets like NYSE.
2. There is a verification procedure when you open your account where you may have to submit/post some documents. The overall approval procedure may take a couple of days or more.
3. The money you invest in foreign stocks is kept in dollars (or other currency). Thus apart from stock market fluctuations you are also exposed to the risk of currency fluctuations.

How to invest in stock market? - Short Listing stocks

Stock Market movements and emotions

A typical week for an early investor -

You are new to stock market. The stock market index has recently gained over 10% in the past one month. Being excited about the movement you have a look at top gainers in the past week. You pick one or two stocks and then justify why these stocks are one of the best available, and also why the price is reasonable. You buy them, wait for a day or two. Unfortunately the stock market retreats and you lose over 10% of your invested value. You then start doubting your stock picks and mange to find a flaw. You decide to rearrange your portfolio and sell a portion of it and buy some of the other stocks which have been relatively stable during the recent market fall. But alas, in the coming week, the stock market rebounds and you realize that had you kept your earlier stocks, you could have done better... frustrated, you start searching the internet for investing strategies..

Does this sound familiar? This is what typically happens to new investors in stock market who do not have a fixed investment strategy.

Have a fixed criterion to short list stocks

It is important to have a fixed idea of what is the minimum you expect from a company whose stock you may consider for buying. As an example, I will give the following criterion which I try to follow.

1. The company must be fully functional and shown a positive net profit for at least 5 years.
2. The average topline growth of the company must be at least 15% in the past 5 years.
3. Minimum Operating Profit margin of 10% and ROCE (return on capital employed) of 12%.
4. The current stock price must not be more than 80% of the 52 week high price. (this is to avoid past experiences where I have invested right when the price was at its maximum, and had to pull out when the price plummeted).
   

It is also good to follow other rules of diversification (not putting most of your money in your top favorite stock), always keeping some cash ready to buy more if the price drops further etc. These other strategies will be discussed in later posts.