ROE indicates how much profit the company is making for every Rs1 of shareholder equity. Shareholder’s Equity is also called as Net Worth of the company.
Return on Equity = Net Profit / Shareholder’s Equity
The Shareholder Equity of the company XYZ is Rs 5000 Cr and the net profit is Rs 1250 Cr. The Return on Equity is 25%.
For every Rs1 of shareholder’s equity, the company is earning Rs 0.25
How to Use Practically
As a rule of thumb, firms that are consistently able to generate ROEs above 15% are generating solid returns on shareholders’ money, which means they are likely to have a strong competitive advantage.
ROE should be used in conjunction with the Debt to Equity ratio because companies with a high D/E ratio artificially have high ROE and this doesn’t give any meaningful economic sense about the company.
Make sure that while analyzing companies look for high ROE and Low D/E ratio companies.
The metric is particularly important when analyzing a bank’s performance due to the correlation between their ROE and Market Cap to Net worth ratio.
Leverage plays an important role in determining the ROE of the business that’s why ROE is an important metric used to analyze banks. Since Banks have a high leverage ratio and dilute the shareholder’s equity to raise money.