One of the best investments we can make is in our own knowledge and skill set. With that in mind, this article will work through how we can use Return On Equity (ROE) to better understand a business. We’ll use ROE to examine ICICI Prudential Life Insurance Company Limited (NSE:ICICIPRULI), by way of a worked example.

Our data shows ICICI Prudential Life Insurance has a return on equity of 27% for the last year. Another way to think of that is that for every ₹1 worth of equity in the company, it was able to earn ₹0.27.

Check out our latest analysis for ICICI Prudential Life Insurance

How Do You Calculate Return On Equity?

The formula for ROE is:

Return on Equity = Net Profit ÷ Shareholders’ Equity

Or for ICICI Prudential Life Insurance:

27% = ₹17.7b ÷ ₹66.2b (Based on the trailing twelve months to June 2018.)

Most know that net profit is the total earnings after all expenses, but the concept of shareholders’ equity is a little more complicated. It is all earnings retained by the company, plus any capital paid in by shareholders. The easiest way to calculate shareholders’ equity is to subtract the company’s total liabilities from the total assets.

What Does Return On Equity Signify?

Return on Equity measures a company’s profitability against the profit it has kept for the business (plus any capital injections). The ‘return’ is the profit over the last twelve months. That means that the higher the ROE, the more profitable the company is. So, as a general rule, a high ROE is a good thing. Clearly, then, one can use ROE to compare different companies.

Does ICICI Prudential Life Insurance Have A Good ROE?

One simple way to determine if a company has a good return on equity is to compare it to the average for its industry. The limitation of this approach is that some companies are quite different from others, even within the same industry classification. Pleasingly, ICICI Prudential Life Insurance has a superior ROE than the average (16%) company in the insurance industry.

That is a good sign. I usually take a closer look when a company has a better ROE than industry peers. One data point to check is if insiders have bought shares recently.

Why You Should Consider Debt When Looking At ROE

Most companies need money — from somewhere — to grow their profits. The cash for investment can come from prior year profits (retained earnings), issuing new shares, or borrowing. In the first and second cases, the ROE will reflect this use of cash for investment in the business. In the latter case, the debt required for growth will boost returns, but will not impact the shareholders’ equity. That will make the ROE look better than if no debt was used.