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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 Marvel Decor Limited (NSE:MDL), by way of a worked example.
Our data shows Marvel Decor has a return on equity of 8.0% 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 ₹0.080.
View our latest analysis for Marvel Decor
How Do You Calculate ROE?
The formula for return on equity is:
Return on Equity = Net Profit ÷ Shareholders' Equity
Or for Marvel Decor:
8.0% = ₹36m ÷ ₹440m (Based on the trailing twelve months to March 2019.)
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 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?
ROE measures a company's profitability against the profit it retains, and any outside investments. The 'return' is the profit over the last twelve months. A higher profit will lead to a higher ROE. So, as a general rule, a high ROE is a good thing. That means it can be interesting to compare the ROE of different companies.
Does Marvel Decor 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. If you look at the image below, you can see Marvel Decor has a lower ROE than the average (11%) in the Consumer Durables 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. Still, shareholders might want to check if insiders have been selling.
How Does Debt Impact 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.