Return on Equity
Also written ROE · Return on Equity (ROE) · Return on net worth · RONW
Profit after tax as a percentage of shareholders' net worth — what the company earned on the money its owners have left in it.
In plain language
If you had put the entire net worth of the company into a fixed deposit instead, you would earn the deposit rate. Return on equity is what the business earned on that same money.
It is the single number that says whether management is creating value or merely occupying assets. A business earning 9% on equity when a government bond yields 7% is barely worth the risk of owning.
How it works
The DuPont breakdown is what makes ROE analytically useful, because it shows where the return comes from:
ROE = Net margin × Asset turnover × Financial leverage
= (PAT ÷ Sales) × (Sales ÷ Assets) × (Assets ÷ Equity)
Three very different companies can report the same 20% ROE — a luxury brand with fat margins and slow turnover, a supermarket with thin margins and fast turnover, and a leveraged finance company with ordinary margins and a large balance sheet. Only the breakdown tells them apart, and only the breakdown reveals that the third one's ROE will collapse if credit tightens.
The formula
ROE = Profit after tax ÷ Average shareholders' equity × 100
Use average equity — opening plus closing, divided by two — where the company raised or returned capital during the year.
A worked example
Two companies, both reporting ROE of 18%:
| Company A | Company B | |
|---|---|---|
| Sales | Rs 2,000 cr | Rs 2,000 cr |
| Profit after tax | Rs 180 cr | Rs 90 cr |
| Net margin | 9% | 4.5% |
| Total assets | Rs 1,800 cr | Rs 1,800 cr |
| Equity | Rs 1,000 cr | Rs 500 cr |
| Debt | Rs 800 cr | Rs 1,300 cr |
| ROE | 18% | 18% |
Company A earns its 18% from profitability. Company B earns its 18% from borrowing — its net margin is half A's, and the gap is closed by leverage of 3.6× against A's 1.8×.
If interest rates rise 200 basis points, B pays roughly Rs 26 crore more in interest and its ROE falls to about 13%. A barely moves. Identical headline ratio; entirely different risk.
Why NISM asks about it
Chapter 8 calls ROE the single most important parameter for an equity investor to start digging into a company. Expect DuPont decomposition questions, and questions that give you two companies with equal ROE and ask which is the better business — the answer is the one whose ROE comes from margin or turnover rather than leverage.
Common exam traps
- High ROE can be a warning. A company that has bought back most of its equity, or written off assets, has a small denominator. The ratio rises while the business does not improve.
- Negative equity makes ROE meaningless, not excellent. A negative denominator with negative profit produces a positive percentage.
- Do not confuse ROE with ROCE, which uses capital employed (equity plus debt) and so is not distorted by leverage.
- ROE says nothing about the price you pay. A superb business at a silly price is still a bad investment — that is what valuation is for.
Check yourself
1.HighLevCo reports an ROE of 92.3% against LowLevCo's 52.4%. DuPont shows HighLevCo has an asset turnover of 2.3x against 2.4x, a net profit margin of 20% against 22%, and an assets-to-equity multiplier of 2.0x against 1.0x. What is the correct conclusion?
- a)HighLevCo is the better performer, since a higher ROE always reflects better management
- b)LowLevCo is the better operator; HighLevCo's higher ROE comes entirely from leverage, which also brings higher risk
- c)The two are equally good, since ROE differences below 50 percentage points are not meaningful
- d)HighLevCo is better because higher leverage is itself a sign of superior capital allocation
Show the answer
Answer: (b) LowLevCo is the better operator; HighLevCo's higher ROE comes entirely from leverage, which also brings higher risk
This is the workbook's own illustration and its own conclusion. Decomposing the ROE reverses the surface reading: LowLevCo is doing marginally better on asset turnover (2.4x vs 2.3x) and reasonably better on profit margin (22% vs 20%). Its only weakness is low leverage — an assets-to-equity multiplier of 1.0x against 2.0x, meaning it carries no debt at all.
So LowLevCo is the better performer in operations, and its lower ROE simply reflects lower levels of debt, which also reduces the risk the company faces.
The governing rule: ROE can rise from higher margin, higher efficiency, or higher leverage. The first two are a reason to cheer. Higher leverage need not be, because it also brings higher risk. Option D inverts that rule exactly.
2.A company has a price-to-earnings ratio of 10 and a price-to-book-value ratio of 5. Its book value per share is ₹15 and 10,000 shares are outstanding. What is its return on equity?
- a)25%
- b)75%
- c)50%
- d)20%
Show the answer
Answer: (c) 50%
Set the ratios against each other and price cancels out.
ROE = Earnings ÷ Book value = (Price ÷ Book value) ÷ (Price ÷ Earnings) = P/BV ÷ P/E
= 5 ÷ 10 = 0.5 = 50%
You can verify it the long way. Book value per share ₹15 and P/BV of 5 give a price of ₹75. A P/E of 10 gives EPS = 75 ÷ 10 = ₹7.50. ROE = 7.50 ÷ 15 = 50%.
Notice that the share count of 10,000 is irrelevant — every quantity here is per share, so the number of shares cancels. It is in the question purely to invite unnecessary work, and it is a common feature of NISM numericals: check which given figures the formula actually needs before you start multiplying.
20% is the answer from inverting the ratio (10 ÷ 5 = 2, misread), and 25% and 75% come from combining the numbers arbitrarily.
3.A company earns PAT of ₹234 crore for the year. Its net-worth was ₹1,700 crore at the start of the year and ₹1,900 crore at the end. Following the workbook’s method, what is its ROE?
- a)13.0%
- b)12.3%
- c)13.8%
- d)6.5%
Show the answer
Answer: (a) 13.0%
ROE = PAT ÷ Net-worth, but the denominator must be an average: "while sales and net profit is for a given period, net-worth and asset balance are as at a particular date. To compare the two metrics, we should use the average net-worth during the period." Since daily balances are hard to get, "the average balance is often calculated by taking average of opening and closing balances."
Average net-worth = (1,700 + 1,900) ÷ 2 = ₹1,800 crore ROE = 234 ÷ 1,800 = 13.0%
How each wrong option is built:
- 12.3% uses the closing net-worth (234 ÷ 1,900).
- 13.8% uses the opening net-worth (234 ÷ 1,700).
- 6.5% adds the two balances without halving (234 ÷ 3,600).
The workbook applies the same method to Bharti Airtel FY2019: average net-worth (8,49,486 + 7,83,483) ÷ 2 = 8,16,485, and ROE = 16,875 ÷ 8,16,485 = 2.1%. It calls ROE "the single most important parameter for an equity investor to start digging for more information about a company."
Where this is taught
Free preparation for NISM Series XVRelated terms
- Diluted EPSEarnings per share recalculated as if every instrument that can convert into equity had already converted — the pessimistic, and usually the more honest, share count.
- EBITDAProfit from running the business, measured before interest, tax, depreciation and amortisation — so before how the company is funded and how it accounts for its assets.
- Intrinsic valueWhat an asset is actually worth — the present value of the cash it will generate over its remaining life, as against whatever price the market is quoting today.
- Quick ratioCurrent assets excluding inventory, divided by current liabilities — a stricter liquidity test than the current ratio, because inventory cannot reliably be turned into cash in a hurry.
- Return on Capital EmployedOperating profit as a percentage of all the capital in the business, equity and debt together — the return the enterprise earns before any question of how it was funded or taxed.
- Price to Book ValueShare price divided by book value per share — how many times the accounting net worth of a company the market is willing to pay.
- MoatThe durable competitive advantage that lets a company keep earning high returns while competitors try and fail to take its business.
- BuybackA company purchasing its own shares out of reserves and extinguishing them, reducing share capital and raising earnings per share for the shareholders who remain.
- Other Comprehensive IncomeGains and losses that Ind AS requires or permits to bypass the profit and loss account — they change shareholders' equity and never touch earnings per share.
- DuPont analysisBreaking return on equity into net profit margin × asset turnover × equity multiplier, to see whether ROE comes from profitability, efficiency or borrowing.
- Dividend Payout RatioDividend per share divided by earnings per share — the share of profit a company hands to shareholders rather than ploughing back into the business.
- Contingent liabilityAn obligation that may or may not arise, depending on the outcome of an uncertain future event — a lawsuit, a tax dispute, a guarantee — disclosed in the notes rather than booked in the accounts.
- Basis pointOne-hundredth of one percentage point — the standard unit analysts use to describe small, exact changes in margins, yields and interest rates without ambiguity.
- Book valueA company's net worth — equity capital plus reserves — divided by its outstanding shares, the accounting value each share would theoretically get if the company wound up today.
- Companion variablesThe fundamental metric an analyst must read alongside a valuation multiple — such as growth with P/E, or ROIC with EV/EBITDA — to judge whether a low multiple is cheap or a warning.
- Checklist approachUsing a fixed, written list of qualitative, quantitative and valuation questions before every investment decision, so judgement stays disciplined rather than based on memory or mood.
- Return on equity under leverageHow borrowing changes the return an investor earns on their own money — in the workbook's own caselet, a 10% yielding asset bought with 1.4 times leverage returns 11.4% on the investor's own funds.
- Economic Value AddedA company's after-tax operating profit less a charge for the capital employed to earn it — the profit that remains after the providers of capital have been paid what they required.
- Market Value AddedThe difference between the current market value of a firm and the original capital its investors contributed — positive means the firm has added value, negative means it has destroyed it.