When it comes to making good money from equities, a lot is being talked about dividend paying stocks and their growth trajectories. However, simply reading the financial numbers on yields of the company is not enough to understand the future potential and growth. An investor must know the reason behind the growth and other factors that can assist the organization to flourish further. There are multiple financial factors that need to be looked at before making any investing decision. Of which, Return on Equity (RoE) is the one that tells us about the profitability of the company in terms of profit generated from shareholders’ money. It is calculated by dividing Profit after tax (PAT) with average of shareholders’ equity. Profitability means that how much money a firm can earn after incurring all the expenses during the period.
The significance of RoE ratio relates to the firm’s ability to generate profits from the shareholder investment. Higher RoE ratio is better for shareholders as it implies that the company is increasing its ability to generate adequate profit without the need of higher capital and gives a positive outlook about the stock. It also indicates that how well the company’s management is deploying the shareholders’ capital into the firm. However, RoE does not represent risk associated with the return. In order to get this right, an organization may sometimes depend on debt to produce an extraordinary net benefit, which results in higher ROE. On the other hand, downward trend of RoE indicates that the company’s management is making a poor decision and is investing its capital in unrewarding assets.
Let’s understand the RoE derivation through an example – Australian Finance Group Ltd (ASX: AFG) generated $39.1 Mn of Profit after tax in FY17 and average shareholder equity amounted close to about $100 Mn then it’s RoE ratio as per the above formula comes at a value over 39 per cent. This represents the return that management is earning on shareholder equity, thus resulting into higher dividend payment; and it is worth noting that AFG’s dividend yield is around 6.89 per cent.
It should also be noted that ROE can help compare companies in the same sector to see which company can effectively use the cash for greater returns.
Telecom Sector Stocks – Vocus and Telstra with ROE in last three years
Eventually, ROE is an important indicator used in evaluating a stock as it generally correlates well with dividend growth over time.
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