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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. We'll use ROE to examine Punjab Chemicals and Crop Protection Limited (NSE:PUNJABCHEM), by way of a worked example.
Our data shows Punjab Chemicals and Crop Protection has a return on equity of 18% for the last year. One way to conceptualize this, is that for each ₹1 of shareholders' equity it has, the company made ₹0.18 in profit.
Check out our latest analysis for Punjab Chemicals and Crop Protection
How Do I Calculate Return On Equity?
The formula for return on equity is:
Return on Equity = Net Profit ÷ Shareholders' Equity
Or for Punjab Chemicals and Crop Protection:
18% = ₹168m ÷ ₹909m (Based on the trailing twelve months to March 2019.)
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. The easiest way to calculate shareholders' equity is to subtract the company's total liabilities from the total assets.
What Does Return On Equity 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. That means that the higher the ROE, the more profitable the company is. So, all else being equal, a high ROE is better than a low one. That means ROE can be used to compare two businesses.
Does Punjab Chemicals and Crop Protection Have A Good Return On Equity?
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 you can see in the graphic below, Punjab Chemicals and Crop Protection has a higher ROE than the average (13%) in the Chemicals industry.
That's clearly a positive. In my book, a high ROE almost always warrants a closer look. One data point to check is if insiders have bought shares recently.
How Does Debt Impact ROE?
Most companies need money -- from somewhere -- to grow their profits. The cash for investment can come from prior year profits (retained earnings), issuing new shares, or borrowing. 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. In this manner the use of debt will boost ROE, even though the core economics of the business stay the same.