An equity investor wants to maximise his returns. The company in which he is invested should also try to do that. Return on equity (RoE; also called return on net worth) is an important profitability measure. A high RoE means that the company is utilising its equity, which is the capital provided by the investors, in an efficient way.
An analysis of the return on equity of BSE 500 companies over the past five years presents an interesting picture. We categorised RoE in various ranges and found out the number of companies in each range. The number of companies with a very high (over 30 per cent) RoE has gone down in the past five years. Ditto for the companies in the 20-30 per cent RoE bracket. The number of companies in lower RoE ranges (0-10 per cent) have gone up.
Indian companies have historically enjoyed high profitability compared to those in developed and other emerging economies. Hence, Indian equities have commanded premium valuation. As seen in the current trend, many companies are still in the higher RoE ranges but the momentum is waning. This should ring alarm bells among investors.
This story first appeared in June 2016.