In This Article:
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 Sterling Tools Limited (NSE:STERTOOLS).
Sterling Tools has a ROE of 20%, based on the last twelve months. One way to conceptualize this, is that for each ₹1 of shareholders’ equity it has, the company made ₹0.20 in profit.
Check out our latest analysis for Sterling Tools
How Do You Calculate ROE?
The formula for return on equity is:
Return on Equity = Net Profit ÷ Shareholders’ Equity
Or for Sterling Tools:
20% = 490.518 ÷ ₹2.4b (Based on the trailing twelve months to March 2018.)
Most readers would understand what net profit is, but it’s worth explaining the concept of shareholders’ equity. It is all earnings retained by the company, plus any capital paid in by shareholders. The easiest way to calculate shareholders’ equity is to subtract the company’s total liabilities from the total assets.
What Does ROE Mean?
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. The higher the ROE, the more profit the company is making. So, as a general rule, a high ROE is a good thing. Clearly, then, one can use ROE to compare different companies.
Does Sterling Tools 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, Sterling Tools has a better ROE than the average (12%) in the machinery industry.
That’s clearly a positive. We think a high ROE, alone, is usually enough to justify further research into a company. One data point to check is if insiders have bought shares recently.
The Importance Of Debt To Return On Equity
Most companies need money — from somewhere — to grow their 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 Sterling Tools’s Debt And Its 20% Return On Equity
While Sterling Tools does have some debt, with debt to equity of just 0.14, we wouldn’t say debt is excessive. The combination of modest debt and a very respectable ROE suggests this is a business worth watching. Careful use of debt to boost returns is often very good for shareholders. However, it could reduce the company’s ability to take advantage of future opportunities.