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 Penta Gold Limited (NSE:PENTAGOLD), by way of a worked example.

Penta Gold has a ROE of 8.8%, based on the last twelve months. That means that for every ₹1 worth of shareholders' equity, it generated ₹0.09 in profit.

See our latest analysis for Penta Gold

How Do I Calculate Return On Equity?

The formula for return on equity is:

Return on Equity = Net Profit ÷ Shareholders' Equity

Or for Penta Gold:

8.8% = ₹30m ÷ ₹339m (Based on the trailing twelve months to March 2019.)

Most know that net profit is the total earnings after all expenses, but the concept of shareholders' equity is a little more complicated. 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 ROE Signify?

ROE measures a company's profitability against the profit it retains, and any outside investments. The 'return' is the yearly profit. A higher profit will lead to a higher ROE. So, all else equal, investors should like a high ROE. That means it can be interesting to compare the ROE of different companies.

Does Penta Gold 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. Importantly, this is far from a perfect measure, because companies differ significantly within the same industry classification. As is clear from the image below, Penta Gold has a better ROE than the average (2.6%) in the Retail Distributors industry.

That is a good sign. In my book, a high ROE almost always warrants a closer look. For example, I often check if insiders have been 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 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 debt used for growth will improve returns, but won't affect the total equity. That will make the ROE look better than if no debt was used.

Penta Gold's Debt And Its 8.8% ROE

Penta Gold clearly uses a significant amount of debt to boost returns, as it has a debt to equity ratio of 1.92. The combination of a rather low ROE and significant use of debt is not particularly appealing. Investors should think carefully about how a company might perform if it was unable to borrow so easily, because credit markets do change over time.