Return on equity

Return on equity is the single most powerful ratio. It can even light on the management quality and where companies are manipulating their accounts or not. High and constant ROE is an indication that the management is utilizing the capital effectively. Manipulating account means you have to either overstate the assets portion of the balance sheet or inflate the expense side of the income statement. The beauty is any such occurrence will automatically lower the Return on Equity. Suppose you are overstating profit, so you have to inflate revenue and understate expenses. Now, your fictitious profit must be stored in the assets portion of the balance sheet. By doing so, you are lowering return in equity. So, companies which are manipulating their books cannot report high ROE consistently. Always consider the best 5 year’s average ROE. The last 5 year’s average ROE of more than 20% indicates that the company is unlikely manipulating their accounts. Companies having last 5 year’s average ROE of more than 20% not only offers immense upside potential but also protects the downside risk. Considering other financial parameters remain same, stocks with increasing ROE would perform better than their counterparts.