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Return on Equity (ROE) is also known as return on net worth. It measures the rate of return on the shareholder’s equity. It measures the firm’s efficiency at generating profits from every unit of shareholder’s equity. It is calculated as below.
ROE= Net Income after tax (PAT)/Shareholder’s Equity
Not all high ROE companies are good investment. Some industries have high ROE because they require no assets, such as consulting firms, IT industry etc. Other industries require large infrastructure builds before they generate a penny of profit such as oil refiners, steel etc. You can’t conclude that consulting firms are better investment than refiners just because of their of ROE. Generally capital-intensive businesses have high barriers to entry, which limit competition. But high ROE firms with small asset base have lower barrier to enrty. Thus, such firms face more business risk because competitors can replicate their success without having to obtain much outside funding.
ROE is best used to compare companies in the same industry. ROE is presumably irrelevant if the earnings are not reinvested.
Du Point Formula:
ROE= (Net Income/Sales) X (Sales/Total Assets) X (Totals Assets/Average Stockholder’s Equity)
