5th October 2007, 08:04 PM
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Sachin Asher
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Join Date: Sep 2006
Location: Vadodara
Posts: 8,621
Rep Power: 383
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Those figures are not the equity figures, but the figures for the share capital.
The accounting definition for "equity" is assets minus liabilities. It is the same as book value.
The share capital is the amount of money that a company has got by issuing its shares.
(The premium over face value goes to "Reserves and Surpluses".
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Equity for a company is not important, but what is important is the ROE that the company gets.
Return on Equity (%) = (Net profit / Equity) X 100%.
The more the ROE is, the better. ROE indicates how efficiently the company is using the equity to generate profits.
In certain industries, the initial equity required is very large.
e.g. In oil exploration industry, lot of assets need to be created first and then profits trickle in.
On the other hand, businesses like consulting require minimum assets. Such businesses make profits from the word go.
Hence a consulting business will usually have a much better ROE compared to an oil exploration company.
It does not make sense to compare ROE for companies in different sectors.
Companies in the same sector can be compared using ROE.
A company having better ROE will grow faster if the profits are reinvested.
However, if the profits are not reinvested, then there is not much benefit of having a better Return on Equity.
e.g.
Company A has equity of Rs 10 and makes Rs 2 profit - 20% ROE.
Company B has equity of Rs 2 and makes Rs 2 profit - 100% ROE.
B has better ROE.
Case I:
Both companies reinvest profits back in business.
After 1 year:
Company A will have equity of Rs 12 and profits of Rs 2.4.
Company B will have equity of Rs 4 and profits of Rs 4.
Thus even though both companies have same earnings, B will get higher PE ratio from the market. Its future growth is expected to be faster because of higher ROE.
Case II:
B gives away profits as dividends.
After 1 year:
Company A will have equity of Rs 12 and profits of Rs 2.4.
Company B will have equity of Rs 2 and profits of Rs 2.
Thus even if B has a better ROE, it is not able to use it to increase earnings. In such a case B will not get the same type of valuation that it could have got in Case I.
Company B will keep giving Rs 2 dividends, but A will keep growing. After a few years, A will actually have far higher earnings than B.
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. For the first time, I think I understand what ROE is. Never too late to learn.
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