In This Article:
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 Maan Aluminium Limited (NSE:MAANALU).
Maan Aluminium has a ROE of 21%, based on the last twelve months. One way to conceptualize this, is that for each ₹1 of shareholders' equity it has, the company made ₹0.21 in profit.
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How Do I Calculate ROE?
The formula for ROE is:
Return on Equity = Net Profit ÷ Shareholders' Equity
Or for Maan Aluminium:
21% = ₹92m ÷ ₹437m (Based on the trailing twelve months to June 2019.)
It's easy to understand the 'net profit' part of that equation, but 'shareholders' equity' requires further explanation. It is all the money paid into the company from shareholders, plus any earnings retained. The easiest way to calculate shareholders' equity is to subtract the company's total liabilities from the 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 amount earned after tax over the last twelve months. The higher the ROE, the more profit the company is making. So, all else equal, investors should like a high ROE. Clearly, then, one can use ROE to compare different companies.
Does Maan Aluminium 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. As is clear from the image below, Maan Aluminium has a better ROE than the average (11%) in the Metals and Mining industry.
That's clearly a positive. In my book, a high ROE almost always warrants a closer look. For example, I often check if insiders have been buying shares.
How Does Debt Impact ROE?
Companies usually need to invest money to grow their 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. Thus the use of debt can improve ROE, albeit along with extra risk in the case of stormy weather, metaphorically speaking.