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Stock Picking is a science as well as an art. Improve your stock picking skills by understanding the science behind it – it is much easier than learning the art of stock picking.

Assuming everything else remains the same, would you invest in a company that returns 10% or the one that returns 20%?

This is exactly where Return on Equity or ROE comes in.
As investors, when we buy shares in a company, we own a fraction of equity. Equity is the money that the company invests to do business and make more money.
Since we, the investors, own the equity, it makes sense to know what the return on our equity is.
ROE is calculated by dividing the net profit by the sum of shareholders’ equity and expressing this as a percentage.
Simplicity of ROE
It is easy to obtain the net profit and shareholders’ equity from the financial statements. Since the calculation is simple, we can compare the return on equity of companies and identify which company performs better. If a company performs better, we can hope that the share price will also do better!

Flip Side of ROE
As the formula suggests, the ROE will increase if:

  • The net profit increases
  • The Equity decreases

The equity decreases when a company buys back shares. In this case, even if the net profit is not that great, the ROE may look too good to be true. However, in the ROE growth, we are really interested in seeing the net profits grow.
In the Indian stock market, MNCs have been buying back the equity over the last few years. Some of the examples of MNCs with very high ROE in 2014 are:

  • Hindustan Unilever – 101
  • Colgate Palmolive – 82
  • Accelya Kale – 78
  • Castrol India – 65
  • Britannia Ind – 48

I haven’t analyzed the stock buyback pattern of all these companies, but that should be the next step before investing in them.
It is always a good idea to look at the ROE trend of a company over the years. Consistency in the ROE number tells us that the returns are consistent. My favorite example is TCS. The ROE for the last four years are 36, 35, 36 and 38 respectively.

Here’s a list of companies listed in India with very high ROE.

Stock Picking  - Understanding the importance of ROE

Stock Picking – Understanding the importance of ROE

In my book, ‘Stock Picking Made Easy’, you will find a simple strategy to identify great companies at reasonable valuations in the Indian Stock Exchange. Identifying great companies at the right time is the key to long term wealth creation.

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