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Many investors are still learning about the various metrics that can be useful when analysing a stock. This article is for those who would like to learn about Return On Equity (ROE). We’ll use ROE to examine Ambika Cotton Mills Limited (NSE:AMBIKCO), by way of a worked example.
Over the last twelve months Ambika Cotton Mills has recorded a ROE of 14%. That means that for every ₹1 worth of shareholders’ equity, it generated ₹0.14 in profit.
Check out our latest analysis for Ambika Cotton Mills
How Do You Calculate ROE?
The formula for ROE is:
Return on Equity = Net Profit ÷ Shareholders’ Equity
Or for Ambika Cotton Mills:
14% = 658.677 ÷ ₹4.6b (Based on the trailing twelve months to December 2018.)
Most readers would understand what net profit is, but it’s worth explaining the concept of shareholders’ equity. It is the capital paid in by shareholders, plus any retained earnings. You can calculate shareholders’ equity by subtracting the company’s total liabilities from its total assets.
What Does ROE 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 yearly profit. 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. That means ROE can be used to compare two businesses.
Does Ambika Cotton Mills 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, Ambika Cotton Mills has a superior ROE than the average (8.1%) company in the Luxury industry.
That’s what I like to see. In my book, a high ROE almost always warrants a closer look. For example you might check if insiders are buying shares.
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 use of debt will improve the returns, but will not change the equity. That will make the ROE look better than if no debt was used.