What is ultimate factor in investment? Efficiency? Return? Share price? Management? Infact it is combination of all of them. So the question is how to check all of them?
Answer is Return on Equity.
The reason is this
It is Trademarked Formula of Return On Equity, Registered by DuPont’s.
In short Return On Equity is the money Earn on 1 ₹/$ Of shareholders Equity including Undistributed Profit or reserve.
While valuation, not only Profit but also how much profit is earn is also important. Like ₹20 million (20000000) Profit may look Good but for the size of ₹10 Billion may look not look Good and AFFECT Price to earning ratio.
It is also important on how much money is invested in the business i e Efficiency. Say 20 million may look Good but for E-Commerce or company which operating in Capital Intensive Sector is earning it on very big Equity.
How the company is earning is also important. Weather assets are performing better? If yes then its Good signal. There are some companies which are continuously performing above 100 % potential. One thing about Asset is that they are continuously depreciating. So if the company is not making Capital investment or Capital Work In Progress, more than The depreciation, than the life of the Asset is low. Not good for company.
If the company is making it with Leverage, then it’s double edge sword. Slight change in Topline will make big Change in Profit but if the Topline is reducing then?
It is important for Value Investing as it is showing what is the return of Equity. The beauty of the formula Is it is telling at what is a rate of growth of the company. Just like the speedometer on your vehicle. It also tell what is total efficiency of management and company. If the RoE of the company is lower than RFR for the country then its not worth to invest in the company.
Going to end the Post
If ROE is lower than ( % Capital Gain + Dividend yield) then the stock is Overvalued. RoE = % Capital Gain + Dividend yield.
Which actually prove Warren Buffett about Retained earning. If the company is not making ₹1 market capitalization for ₹1 retained earnings than don’t invest in it.
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