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One of the best investments we can make is in our own knowledge and skill set. With that in mind, this article will work through how we can use Return On Equity (ROE) to better understand a business. To keep the lesson grounded in practicality, we'll use ROE to better understand HDFC Life Insurance Company Limited (NSE:HDFCLIFE).
Over the last twelve months HDFC Life Insurance has recorded a ROE of 23%. That means that for every ₹1 worth of shareholders' equity, it generated ₹0.23 in profit.
Check out our latest analysis for HDFC Life Insurance
How Do You Calculate Return On Equity?
The formula for ROE is:
Return on Equity = Net Profit ÷ Shareholders' Equity
Or for HDFC Life Insurance:
23% = ₹13b ÷ ₹56b (Based on the trailing twelve months to March 2019.)
Most readers would understand what net profit is, but it’s worth explaining the concept of shareholders’ equity. It is all the money paid into the company from shareholders, plus any earnings retained. 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. A higher profit will lead to a higher ROE. So, as a general rule, a high ROE is a good thing. Clearly, then, one can use ROE to compare different companies.
Does HDFC Life Insurance Have A Good ROE?
By comparing a company's ROE with its industry average, we can get a quick measure of how good it is. Importantly, this is far from a perfect measure, because companies differ significantly within the same industry classification. Pleasingly, HDFC Life Insurance has a superior ROE than the average (18%) company in the Insurance industry.
That's what I like to see. I usually take a closer look when a company has a better ROE than industry peers. For example you might check if insiders are buying shares.
How Does Debt Impact ROE?
Virtually all companies need money to invest in the business, to grow profits. That cash can come from issuing shares, retained earnings, or debt. In the first two cases, the ROE will capture this use of capital to grow. 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.
Combining HDFC Life Insurance's Debt And Its 23% Return On Equity
HDFC Life Insurance is free of net debt, which is a positive for shareholders. Its ROE already suggests it is a good business, but the fact it has achieved this -- and doesn't borrowings -- makes it worthy of further consideration, in my view. After all, when a company has a strong balance sheet, it can often find ways to invest in growth, even if it takes some time.