One of the factors to determine whether the company whose shares you buy has a good profit rate is to look at its Return On Equity (ROE). In Indonesia, ROE is called the Return on Equity Ratio. How does it work and function so that ROE can show the performance of an issuer?
What is ROE?
ROE is the ratio between net income and total equity or the same as the ratio of EPS (Earning Per Share) divided by the ratio of PBV (Price to Book Value).
ROE is a parameter to measure how much profit the company generates for every rupiah invested. Through ROE also, investors can find out the ability of capital owned by equity to generate net income (earnings after interest and taxes or commonly called earning after interest and tax/EBIT).
In short, the ROE ratio reflects the ability of the company or issuer to manage its equity. ROE ratio is also an important indicator to determine the performance of a company.
For example, a company’s ROE is 20 percent. So every Rp200 of own capital invested in the company is able to provide a net profit of Rp.40.
There are two ways to find out whether an ROE ratio of 20 percent is good or not:
- Comparing a particular company’s ROE ratio with other companies operating in the same sector.
- Next, compare the ROE ratio of a company over a period of time to be able to see the trend, whether it tends to go down or even go up.
ROE can be presented in the form of a percentage or a ratio. The greater the ROE, the better the performance.
However, companies with a high ROE ratio usually also have a high risk because the company has a fairly large debt ratio.
In addition, companies with high ROE ratios also tend to have high PBV. Therefore, choose stocks that have a stable ROE ratio of at least 10 percent.
How to Calculate ROE
Dividing Net Profit By Equity
How to get the ROE figure is quite easy because you only need to divide Net Profit by Equity.
Return on Equity = (Net Profit)/(Company’s equity)
- Net Profit = The difference between all income and all expenses.
- Equity = Difference from Total Assets minus Total Liabilities. Equity is the net capital issued by the company to carry out the company’s operations.
Based on Clean Surplus Accounting (CSA)
The second way to determine ROE can be based on Clean Surplus Accounting (CSA). ROE based on Clean Surplus Accounting is a reflection of the company’s overall performance.
How the management performance, how efficient the system of production, distribution, marketing, human resources, etc., are all reflected in this ratio.
The calculation method is quite easy:
CSA ROE = Net Return/CSA Equity
- Net Return = Current Year’s Profit; if any, then use the Profit for the Year Attributed to the owners of the Parent Entity (not Other Comprehensive Income and Total Comprehensive Income).
- Equity CSA = Last year’s Book Value + Last year’s Retained Earnings.
- Book Value = Total Assets – Total Liabilities.
- Retained Earnings = Net Income for the Year – Dividends.
Very simple, right? The correct calculation of ROE will give an idea of the issuer’s ability to generate profits.
Use EBIT Figures Instead of Net Profit
Net Profit is the final result after everything has been paid. When you want to calculate dividends received, you can check the issuer’s net income.
However, the amount of net profit is influenced by many things, such as the company’s operational activities, taxes paid, interest expenses incurred, to interest on investment returns.
Net Profit will provide a biased figure in the performance analysis because the amount of tax and interest paid varies from year to year.
The interest paid will be based on the debt that is still being carried, but will decrease if the debt is paid little by little.
If you are curious about the ability of issuers to generate profits in their business activities, then you can consider including EBIT instead of Net Profit.
EBIT is Earnings Before Interest and Tax. In short, this is the true face of the company’s quality in operation. EBIT is the actual profit generated from its operational activities only.
If you want to know the ability of the issuer to make a profit, then you should include EBIT / Profit Before Tax in the calculation of ROE.
As an investor, you can consider stocks with an ROE that is close to the long-term average yield of the IHSG, which is 14% a year.