How to Find the Best Indian Companies by Return on Equity

Do you use the Return on Equity (RoE) when deciding which stock to buy?

Well, you should.

The RoE will tell you how the company's management has used its shareholders' money to make profits for them.

When you buy any stock, you become a shareholder of that company. You are putting your hard-earned money in the hands of the management of that company. So, before use invest, you should know how they have made use of shareholders' funds in the past.

This is what the RoE will tell you, at a glance. It's one of the most important financial ratios.

In this article, we will take you through the process of using the RoE properly.

Let's get started.

What Does the RoE Tell You Exactly?

In a nutshell, the RoE tells you how profitable a company is, relative to its book value, i.e., its equity.

Put simply, a company's equity, i.e., its book value, is its total assets minus its total liabilities.

The RoE tells us how much profit the company makes on its equity.

To calculate the RoE just divide the company's net profit by its equity. Consider the latest year's financial statements. The net profit is found in the income statement. The equity is found in the balance sheet.

Return on Equity = Net Profit / Shareholders' Equity

It's as simple as that.

Screening Companies Using RoE as a Filter

Now let's use the Equitymaster Stock Screener to filter companies for your potential investments.

First, let's go to the High RoE Stocks Screener.

It looks like this with a sample of 15 stocks...

There are 7 filters on this screen - current market price (CMP), the latest RoE, the last 3-years average RoE, the last 5-years average RoE, the PE ratio of the stock, the company's marketcap, and the company's debt to equity ratio.

These filters can be customised to your liking. Just click on them once or twice to sort by highest to lowest or lowest to highest.

Why are there 3 filters based on RoE?

Well, that's because when doing detailed analysis of a company, looking at the latest year's RoE isn't enough. Not only that, but you may get the wrong idea about the company.

If the latest RoE is low, it could be due to many factors. Perhaps the margins were hit due to rising raw material costs which are beyond the control of the management. It would be incorrect to make a judgement about the company's fundamentals based on this one point.

This is why averages are important. These numbers give you perspective on the RoE over a period of time. The 3-year average is sufficient to solve the problem of one-year ups and downs. The 5-year average gives you a good idea about how the management has done over a longer-term.

If you are a long-term investor, consider starting the filtering process with the 5-year average.

The PE ratio is important because every investor would like to know how expensive a stock is. Value oriented investor can start their filtering process by sorting companies by their PE ratios from lowest to highest.

If you are a safety-first investor, consider starting your filtering process with the marketcap filter from highest to lowest. If you are a growth-oriented investor, also look at marketcap first but sort from lowest to highest.

Don't forget to look at the debt-to-equity column. Always look at the debt to equity when looking at the latest year RoE. The two go hand in hand. We have explained why below.

Finally, if you are using this screen to find the highest RoE companies, start with the 5-year average filter. Then move to the 3-year average filter. Then check the latest year's RoE. Begin in that order before looking at other parameters.

Now let's examine a couple of important points most people ignore when looking for high RoE stocks.

Avoid This Mistake When Using the RoE

Always compare companies' RoE that are in the same industry. Comparing the RoE of companies in different industries is a big mistake. This is because the industry itself has a major influence on the RoE of the companies operating in it.

Here's a simple example to explain this. Consider a steel company and a software company. Both make the same amount of revenue. However, their RoE will be different.

The steel industry is very demanding in terms of capital investment. The software industry is not. The steel company has to invest much of its profit back into the business to buy and maintain machinery. The software company doesn't have this problem.

So, the steel company's book value, i.e., its equity, is higher than that of the software company, even though both are of the same size in terms of revenue.

As the equity is in the denominator of the equation, the steel company's RoE will be lower that that of the software company.

Debt and RoE

Sometimes companies with high debt can have high RoE. This is not because the company is highly profitable. It's just because the taking on debt, for a given level of assets, will reduce the equity. Thus, the RoE will look artificially high, at least for a while.

The real test for such companies is whether they can maintain the high RoE. This will be evidence that the management has put the debt to good use.

Typically, firms in the same industry will have similar levels of debt or leverage. This is another reason to compare RoE across companies in the same industry.

Keep this point in mind when comparing to companies in the same industry that have significantly different levels of debt.

Happy investing!

Disclaimer: This article is for information purposes only. It is not a stock recommendation and should not be treated as such. Learn more about our recommendation services here...