Introduction:

Navigating the world of stocks can often feel like deciphering a complex code. Evaluating the stocks you invest in is critical. Without understanding the price movements, company history, and future prospects, you add unwanted risk to your portfolio. Amidst the many variables and factors, two fundamental pillars stand tall - Return on Equity (ROE) and valuation.

This article will discuss the intricacies of these two concepts and enable you to grasp their significance in making confident choices in equity investments.

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What is ROE?

ROE is a financial tool that shows how well a company can transform your investment into profits. It measures a company's ability to make money from the money you and other shareholders have put in. It tells you how effectively the company uses its resources to generate earnings. ROE is a simple and straightforward way to compare one company's performance with others in the same field.

You calculate it by taking the company's profit and dividing it by the money that belongs to shareholders (shareholder's equity). The higher the ROE, the better. Here's the formula:

ROE = Net income / Total shareholder's equity of the company

What is valuation?

Valuation is about determining a company's market worth. Investors' expectations influence it and can be measured using tools like market capitalization, Price-to-Earnings ratio (P/E), Price-to-Book ratio (P/B), and Earnings Per Share (EPS). These tools help evaluate if a stock is fairly-priced, overpriced, or underpriced. It gives you a clear idea of where a company stands.

Here's how you can calculate a company's valuation using different tools:

• P/E ratio = (Current market price of a share / Earnings per share)

If the P/E ratio is high, the stock might be pricier than the company's earnings.

• P/B ratio = Current share price/ Book value per share

Here the book value per share = (Total assets – Total liabilities) / Number of outstanding shares

A low P/B ratio indicates an undervalued stock, while a high ratio suggests a high-priced one.

• EPS = (Net income – Preferred dividend) / Outstanding shares

When a company's EPS is high, it often suggests a good chunk of profit available to share with its shareholders in the form of dividends.

ROE vs valuation – which is better?

ROE can help you understand a company's profitability and reflect on its efficiency in generating earnings. It shows you the potential return from your investment but does not factor in the company's current value. If you pay a stock price too high, even a strong management team might not make a big difference in your gains. This is why ROE should not be the sole key for deciding where you put your money. Also, when comparing ROEs, it is essential to ensure they are from similar companies in the same industry. If not, the result may be inconclusive for your research.

On the other hand, valuation helps you gauge whether a stock is priced right, considering various metrics like P/E and P/B ratios and intrinsic value. A company with high earnings and a high P/E ratio may be a bit pricey but can still be a smart choice with a promise to yield returns in the future. However, stocks with a high P/E but low ROE may not be as good as you would pay more for potentially lower returns in the future.

Some investors focus only on ROE when considering where to invest, thinking it is the complete picture. But remember, ROE cannot offer you a comprehensive insight into a company. A better move can be to consider both ROE and valuation ratios together. This can help you spot stocks with potential and the promise of growth.

Summary

ROE and valuation can enable you to spot stocks that promise growth and align with your investment goals. These two concepts work in tandem to offer you a more holistic perspective on stock investing. It may not be prudent to use one and ignore the other. Remember to use them efficiently to navigate the stock market with confidence. You can open a free Demat account with Motilal Oswal to start investing in stocks.

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