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 Mazda Limited (NSE:MAZDALTD), by way of a worked example.

Over the last twelve months Mazda has recorded a ROE of 11%. That means that for every ₹1 worth of shareholders’ equity, it generated ₹0.11 in profit.

View our latest analysis for Mazda

How Do I Calculate ROE?

The formula for return on equity is:

Return on Equity = Net Profit ÷ Shareholders’ Equity

Or for Mazda:

11% = ₹133m ÷ ₹1.3b (Based on the trailing twelve months to December 2018.)

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 ROE Mean?

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. That means that the higher the ROE, the more profitable the company is. So, all else equal, investors should like a high ROE. That means ROE can be used to compare two businesses.

Does Mazda 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 Mazda has a similar ROE to the average in the Machinery industry classification (12%).

That isn’t amazing, but it is respectable. ROE tells us about the quality of the business, but it does not give us much of an idea if the share price is cheap. If you like to buy stocks alongside management, then you might just love this free list of companies. (Hint: insiders have been buying them).

The Importance Of Debt To Return On Equity

Virtually all companies need money to invest in the business, to grow profits. That cash can come from retained earnings, issuing new shares (equity), or debt. 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. In this manner the use of debt will boost ROE, even though the core economics of the business stay the same.