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 Latteys Industries Limited (NSE:LATTEYS), by way of a worked example.
Our data shows Latteys Industries has a return on equity of 5.8% for the last year. One way to conceptualize this, is that for each ₹1 of shareholders' equity it has, the company made ₹0.058 in profit.
See our latest analysis for Latteys Industries
How Do You Calculate ROE?
The formula for ROE is:
Return on Equity = Net Profit ÷ Shareholders' Equity
Or for Latteys Industries:
5.8% = ₹7.9m ÷ ₹136m (Based on the trailing twelve months to March 2019.)
It's easy to understand the 'net profit' part of that equation, but 'shareholders' equity' requires further explanation. It is the capital paid in by shareholders, plus any retained earnings. 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 Mean?
ROE measures a company's profitability against the profit it retains, and any outside investments. The 'return' is the yearly profit. The higher the ROE, the more profit the company is making. So, all else being equal, a high ROE is better than a low one. That means ROE can be used to compare two businesses.
Does Latteys Industries Have A Good Return On Equity?
One simple way to determine if a company has a good return on equity is to compare it to the average for its industry. Importantly, this is far from a perfect measure, because companies differ significantly within the same industry classification. As shown in the graphic below, Latteys Industries has a lower ROE than the average (11%) in the Machinery industry classification.
That's not what we like to see. We'd prefer see an ROE above the industry average, but it might not matter if the company is undervalued. Nonetheless, it might be wise to check if insiders have been selling.
Why You Should Consider Debt When Looking At ROE
Virtually all companies need money to invest in the business, to grow profits. The cash for investment can come from prior year profits (retained earnings), issuing new shares, or borrowing. In the case of the first and second options, the ROE will reflect this use of cash, for growth. In the latter case, the debt used for growth will improve returns, but won't affect the total equity. In this manner the use of debt will boost ROE, even though the core economics of the business stay the same.