What is it
Return on equity (RoE) is calculated by dividing net income of a company by total paid up equity. Here, the net income is considered after paying dividends to preferred shareholders but before paying dividends to common shareholders. It is expressed in percentage term. This figure shows profitability of the company relative to investment by shareholders. In other words, it shows the efficiency of the company in utilizing funds. Hence, higher the RoE better it is. However an RoE of around 15 is considered good by analysts across sectors. RoE is helpful in gauging the profitability of a company among its peer group.
RoE looks simultaneously at profitability, debt and efficiency of the company. Hence a poor performing company can improve its RoE by expanding profit margins, becoming more efficient in using its resources and using its debts more effectively. Investors can see if the company has improved its profitability over time by comparing RoEs at the start and the end of the time period under consideration.
Theoretically, RoE figures tend to return towards a mean value for any sector. Say, if RoE of particular sector is too high from the mean level, it means that companies are making huge profits. This will attract competition and new companies would enter the market thus pulling down RoE to the mean level. Similarly if RoE of a sector is too low, companies would be making losses and thus many companies would exit the market and RoE for rest of the companies would increase and move towards the mean level. However, this need not happen in emerging economies such as India that are in their growth phase and enjoy a higher RoE.
What it means for you
Fresh investors in general do not gain much if the company has a high RoE since he would be paying more if he buys common shares from the secondary market. For existing common shareholders, the benefits may come in the form of dividend. However, the real benefits accrue to shareholders if the company reinvests the earnings to attain even higher level of returns. Hence, investors should keep a watch on the company on how it uses its earnings. RoE can be used in conjecture with other ratios such as price-earnings, earnings per share, debt-equity, etc. by individual investors while picking stocks.