Investing in the stock market comes with its own set of permutations and combinations. We tend to look for the best picks in the market to help generate high returns. And for that, we go through lots of research. We tend to go through the financial data, seek validations in regards to the company’s performance and even seek expert views on it.
During this research, we do look through plenty of things like balance sheets, intrinsic value, cash flow statements and further dwell deep into factors like P.E Ratio majorly as part of our analysis. But there’s something that we often tend to neglect, something that can be one of the hidden cards about the company. It’s Return on Equity (ROE) factor.
As an investor, it is of utmost importance that you look at the profitability of the business before investing in it. And for the pitch-perfect analysis of the profitability of the business, ROE is the perfect tool.
We here look at ROE and why it should be on the prime checklist of yours before investing?
What is Return on Equity (ROE)?
Return on Equity (ROE) is the computation of net income generated by the company as a percentage of the shareholder’s equity. It helps to show how much money a company can generate with the money invested from the shareholders. It checks the profitability stance of the company and helps determine whether the company is a profit-generating one or working inefficiently.
Mathematically ROE is calculated as:
Return on Equity = Net Income/ Shareholder’s Equity
One can easily find the net income and shareholder’s fund from the balance sheet and calculate the ROE with ease. ROE sheds light on the performance of the company and its ability to generate superior returns for the investors. Generally, investors look at the ROE factors of the company over a period of time and compare it to the different companies working in a similar industry to help find the best value-oriented investment.
Why you should check out ROE before Investing in Stock Market?
What if we were to say, even Warren Buffet, The Oracle of Omaha and the richest stock investor around uses ROE to assess the company before investing in it. ROE plays an important role in the company’s financial insight as it provides a hint about whether the company is generating enough profits without having to raise new equity capital. Here are a few reasons why you should look at ROE before investing in the stock market. Read along.
ROE Indicates the Efficiency of the Company in Utilizing Shareholder’s Money
ROE helps to compare the shareholder’s fund and the net income generated by the company. A simple mathematical stat is that the higher the ROE, the efficient will be the company’s operation and utilization of the shareholder’s fund. Often times when a potential investor is looking for a company to invest in, he checks for the ROE and goes with the one with a higher ROE.
The norm around operation and management is that if a company has a higher ROE and is constantly delivering the same over a period of time, then they are more lucrative to invest for as these companies help to grow the shareholder’s wealth substantially. Look for something like ROE of 15% or over.
ROE Determines the Level of Retained Earnings
ROE is much more than just a mere profitability indicator. ROE also helps to showcase the level of retained earnings for the company. A company during its course of operation tends to keep aside a certain portion of profits as part of retained earnings. Retained earnings tend to be the source of capital for a company. A company that has high retained earnings will mostly use the same to operate and generate returns rather than relying on debt capital. This puts them at a good stance for growth.
A high ROE indicates that the company tends to utilize the retained earnings to generate revenues. Check the ROE of the company and have a look at the retained earnings of the previous year for the company from its financial report. You’ll find out one with the high ROE has a good retained earnings with them.
ROE Determines the Company’s Economic Moat
Economic moat, a word popularized by Warren Buffet refers to the ability of the business to maintain a competitive advantage over its competitors. If you look around only those companies that are durable and cater to the good quality business tend to build an economic moat. These companies tend to have a better financial operation and their revenues tend to be on the high. They also have years and years of customer trust backing them for their services and products. The beauty of economic moat is that a company with economic moat can run around for a long period of time and offer good returns for the investor. But how are ROE and economic moat related? The reasoning is that companies with high ROE tend to have a huge economic moat and vice-versa. If a company tends to have high ROE in comparison to its peers in the same industry, it means that the company has an economic moat and can perform better in the long term. So if you find a company with a high ROE and has a competitive advantage over its counterparts in the industry, then it is safe to invest in stocks of such companies while making long term investments over a period of time.
Final Note:
ROE tends to be one of the prominent markers for finding the best shares to invest in. However, it’s not to say that ROE is the perfect tool altogether as plenty of factors come into play when finding the best value-oriented shares. Still, it is one of the handy ones and is used along widely by industry leaders and top investors alike. You can calculate the ROE and leverage it against the corresponding ROE of a similar company to find the optimal value on it.