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While some investors are already well versed in financial metrics (hat tip), this article is for those who would like to learn about Return On Equity (ROE) and why it is important. We’ll use ROE to examine Chennai Petroleum Corporation Limited (NSE:CHENNPETRO), by way of a worked example.
Our data shows Chennai Petroleum has a return on equity of 20% for the last year. That means that for every ₹1 worth of shareholders’ equity, it generated ₹0.20 in profit.
See our latest analysis for Chennai Petroleum
How Do I Calculate Return On Equity?
The formula for return on equity is:
Return on Equity = Net Profit ÷ Shareholders’ Equity
Or for Chennai Petroleum:
20% = 7561.912 ÷ ₹38b (Based on the trailing twelve months to September 2018.)
It’s easy to understand the ‘net profit’ part of that equation, but ‘shareholders’ equity’ requires further explanation. It is all the money paid into the company from shareholders, plus any earnings retained. Shareholders’ equity can be calculated by subtracting the total liabilities of the company from the total assets of the company.
What Does Return On Equity Signify?
ROE looks at the amount a company earns relative to the money it has kept within the business. The ‘return’ is the profit over the last twelve months. That means that the higher the ROE, the more profitable the company is. So, all else equal, investors should like a high ROE. That means ROE can be used to compare two businesses.
Does Chennai Petroleum Have A Good ROE?
Arguably the easiest way to assess company’s ROE is to compare it with the average in its industry. However, this method is only useful as a rough check, because companies do differ quite a bit within the same industry classification. As is clear from the image below, Chennai Petroleum has a better ROE than the average (13%) in the oil and gas industry.
That is a good sign. In my book, a high ROE almost always warrants a closer look. For example, I often check if insiders have been buying shares .
How Does Debt Impact ROE?
Most companies need money — from somewhere — to grow their profits. That cash can come from retained earnings, issuing new shares (equity), or debt. In the first two cases, the ROE will capture this use of capital to grow. In the latter case, the debt used for growth will improve returns, but won’t affect the total equity. That will make the ROE look better than if no debt was used.
Combining Chennai Petroleum’s Debt And Its 20% Return On Equity
It’s worth noting the significant use of debt by Chennai Petroleum, leading to its debt to equity ratio of 1.00. There’s no doubt the ROE is respectable, but it’s worth keeping in mind that metric is elevated by the use of debt. Investors should think carefully about how a company might perform if it was unable to borrow so easily, because credit markets do change over time.