We will also cover the following:
- What is ROE? – Return on Equity Meaning
- How to Calculate ROE? – Return on Equity Formula
- How to Avoid Manipulated ROE
- Return on Equity using the DuPont Model
- List of Companies with Highest ROE
- List of Companies with Highest ROE to avoid
What is ROE? – Return on Equity MeaningReturn on Equity is one of the most important profitability ratios. It measures a company’s ability to generate returns on assets for its equity shareholders. Higher ROE is a positive sign for investors. It means the management is able to generate higher returns on its stockholders equity. . Let us understand what is ROE with this simple example. You want to buy a car costing Rs 5 Lakhs. You plan to run the car in Ola/Uber for some passive income. You have Rs 3 Lakhs and borrow the remaining Rs 2 lakhs from a friend. In the first month, you make a profit of Rs 20,000. Let us calculate your ROE. To calculate ROE, you need to divide net profits by shareholder’s equity. In the above example, your ROE is 6.66% (Rs 20,000/ Rs 3 Lakhs) Now imagine if you only had Rs 2 Lakhs and borrowed Rs 3 lakhs from your friend. Your new ROE is 10%. Note the relationship between debt and return on equity. ROE increases with an increase in debt.
Types of ROE Ratios – Return on Equity TypesThere are two types of ROE ratios:
- Return on Total Equity
- Return on Common Equity (Generally preferred)
- Common Equity Capital - Rs 4,50,000
- Reserves and Surplus – Rs 50,000
- Preference Shareholders – Rs 2,00,000
- Creditors (Debt) – Rs 3,00,000
ROE Formula – Return on Equity Formula
ROE Formula = Net Income / Shareholder’s EquityNet income is the actual income generated by the company after paying interest on debt and dividends to preference shareholders. It does not include dividends paid to common shareholders. It is available in a company’s profit and loss statement (P&L). Shareholder’s Equity = Share Capital + Reserves. It is available in a company’s balance sheet. [Read More: How to Read a Company’s Balance Sheet] Let us use the ROE formula to calculate the Return on Equity of Hindustan Unilever Ltd (HUL). Below is the P&L statement for March 2020. It’s net profit for March 2020 is Rs 6,748 Crores. Let us calculate shareholder’s equity using the below balance sheet. Shareholder’s Equity = Share capital + reserves and surplus = Rs 216 + Rs 8,013 Crores = Rs 8,229 Crores. ROE of HUL Ltd = Rs 6,748 Crores / Rs 8,229 Crores = 82%. [Check out: Should You Invest in HUL Ltd?] Now you must be thinking that HUL’s ROE of 82% is superior to Reliance Industries ROE of 10.20%. Hence its common sense that HUL Ltd is the superior stock. By this logic, Gian Life Care Ltd has an ROE of 1,027%! So, is this the best stock in India? The answer is No! Investors shouldn’t get too excited with high ROE stocks. A high ROE stock can simply be a result of very high debt. Investors should ideally avoid companies with exceptionally high ROE and Debt to Equity (DE) ratios.
What is the Ideal ROE ratio? – Ideal Return on Equity RatioThere is no universal ideal ROE ratio. Return on equity ratio differs from industry to industry. For example, the average ROE of 30 Sensex stocks is 20.67%. Here is sector-wise average return on equity:
|Information & Technology (IT)||31.70%|
|Capital Goods Sector||23.24%|
- 5-Year return on equity of HDFC Bank Ltd
- 5-Year Return on Equity of State Bank of India.
ROE Manipulation TacticsReturn on Equity ratio can be manipulated by:
- Increasing Debt
- Share Buyback
|Equity Share Capital||
|Reserves & Surplus||
|Preferred Equity Capital||
|Interest on Loan||50,000|
|Interest to Preference Shareholders||30,000|
|Profit Before Tax||4,20,000|
|Profit After Tax||2,94,000|
|ROE = (PAT/Total Equity)||2,94,000/ (2,50,000+50,000)|
|Companies||ROE (%)||Debt to Equity||Samco Star Rating|
|S.A.L Steel Ltd||
|Constronics Infra Ltd||
|Bombay Dyeing Mfg Co Ltd||
|Before Share Buyback||
|After Share Buyback||1.44||7.31||
DuPont Model ROE AnalysisDuPont Model is the best way to calculate Return on Equity. It was introduced in the 1920s by DuPont Corporation. It tells you exactly which aspect of the business is driving its return on equity. DuPont model helps investors determine if debt or asset efficiency is the reason behind high ROE DuPont model works on three parameters –
- Operating Efficiency: Net profit margin measures management’s ability to generate higher sales at lower costs. It is calculated by dividing net profit with total sales. A low net profit margin means an inefficient management.
- Asset Efficiency: This shows the management’s ability to utilise its assets for generating profits. It is calculated by dividing net sales and average assets. Higher the asset efficiency, higher would be the profits.
- Financial Leverage: This shows the amount of debt taken to create assets. It is calculated by dividing average total assets by average equity.
|Particulars||FY 1||FY 2|
How to Analyse Stocks Using ROE Ratio?Let us now understand how to analyse stocks using ROE ratio. The below table shows the three financial metrics of the DuPont model for the IT industry. Please note that instead of equity multiplier, we have taken DE ratio as it also measures financial leverage.
(Rs in Crores)
|Return on Equity||Profit Margin||Asset Turnover||
Debt to Equity Ratio
|TATA Consultancy Services Ltd||
|Tech Mahindra Ltd||
|L&T Infotech Ltd||
|Happiest Minds Technologies Ltd||
- Excluding Happiest Minds Technology Ltd, the average return on equity of top 10 stocks in the IT sector is 25.03%.
- TCS is clearly the best stock in the IT industry as seen in its high return on equity, profit margin and low DE ratios.
- Happiest Minds Technologies Ltd has the highest return on equity but its net profit margins are lowest among the top 10 players. A high return on equity backed by high profit margin is acceptable. Unfortunately, that isn’t the case with Happiest Minds Technology.
List of Companies with Highest ROE in India
|High ROE stocks||Return on Equity||Samco Star Rating|
|Nestle India Ltd||105.76%||5 Star|
|Hindustan Unilever Ltd||85.62%||5 Star|
|Colgate-Palmolive (India) Ltd||53.70%||5 Star|
|Tata Consultancy Ltd||39.06%||5 Star|
|Crompton Greaves Consumer Electricals Ltd||38.70%||4 Star|
|Marico Ltd||34.44%||5 Star|
|Rossari Biotech Ltd||31.80%||5 Star|
|HDFC AMC Ltd||30.11%||5 Star|
|Asian Paints Ltd||27.50%||4 Star|
|Pidilite Industries||26.80%||4 Star|
List of Companies with Highest ROE to Avoid
|High ROE but Poor-Quality Stocks||Return on Equity||Samco Star Rating|
|Hathaway Bhawani||389.09%||1 Star|
|Centerac Technologies Ltd||142.86%||1 Star|
|Welcure Drugs & Pharmaceuticals||133.33%||1 Star|
|Gian Life Care Ltd||1027.77%||1 Star|
|Bhansali Engineering Polymers Ltd||64.36%||1 Star|