Stock markets are a reflection of the expected profits in the future. This is why investors should always research about a company - not just its history, but also its future outlook. This can be done by finding trends in the company's financial performance using many profitability measures.
The return on equity (ROE) is one such measure. Here are four important things to know about ROE:
The return on equity is a simple ratio of the company's net profit and its shareholder equity. Shareholders' equity comes from two main sources. The first and original source is the money that was originally invested in the company. The second comes from retained earnings which the company is able to accumulate over time through its operations. It essentially reflects how much profit a company generates for every rupee invested by its shareholders. It is usually expressed as a percentage. The ROE does not take into consideration the money invested by preferred shareholders - a special kind of investor, who is assured a fixed dividend payment every year. It thus represents the company's profitability as earned by common shareholders.
Simply reading numbers about profit and revenue growth is not enough. Investors need to understand the reasons behind the growth and other factors that help the company achieve higher profits. This is why analysts look at other financial measures. The ROE helps understand how the company makes use of its capital assets. Does it use the capital efficiently? Or is it inefficient and spend the money on unwanted resources? This is very important to investors. Firms that use money efficiently go a long way. They have higher chances of succeeding even when times are bad. Since investors profit when the company succeeds, ROE can act as an important indicator.
So how do you read through the numbers? Quite simple. Higher the ROE, greater are the profits generated by the company by using the same amount of resources. Remember, companies do not issue new shares regularly. The only factor that varies is the profit, which depends on the company's revenue as well as costs. So, a rising ROE means that the company is earning more by using the same level of equity. This means it is using the capital efficiently. So, looking at the ROE can give you an idea about the company's growth potential.
Just like any other indicator, it is important that investors look at ROE in relation to other metrics. First of all, ROE can be positive even when both profits and shareholder's equity falls. So, it is important that you compare ROE with the company's profits. Moreover, ROE increases when the value of shareholder's equity falls. This can happen when a company's liabilities and debt increases or when the company buys back its own shares. In reality, this is a negative factor. But looking at the rising ROE, an investor could be fooled. This is why the ROE cannot be considered independently.
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