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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. By way of learning-by-doing, we'll look at ROE to gain a better understanding of Procter & Gamble Hygiene and Health Care Limited (NSE:PGHH).
Over the last twelve months Procter & Gamble Hygiene and Health Care has recorded a ROE of 46%. That means that for every ₹1 worth of shareholders' equity, it generated ₹0.46 in profit.
Check out our latest analysis for Procter & Gamble Hygiene and Health Care
How Do I Calculate ROE?
The formula for ROE is:
Return on Equity = Net Profit ÷ Shareholders' Equity
Or for Procter & Gamble Hygiene and Health Care:
46% = ₹4.2b ÷ ₹9.1b (Based on the trailing twelve months to June 2019.)
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 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 amount earned after tax over the last twelve months. 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. Clearly, then, one can use ROE to compare different companies.
Does Procter & Gamble Hygiene and Health Care Have A Good Return On Equity?
By comparing a company's ROE with its industry average, we can get a quick measure of how good it is. 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, Procter & Gamble Hygiene and Health Care has a better ROE than the average (22%) in the Personal Products industry.
That is a good sign. In my book, a high ROE almost always warrants a closer look. For example you might check if insiders are buying shares.
The Importance Of Debt To Return On Equity
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. Thus the use of debt can improve ROE, albeit along with extra risk in the case of stormy weather, metaphorically speaking.