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 R M Drip and Sprinklers Systems Limited (NSE:RMDRIP), by way of a worked example.
Our data shows R M Drip and Sprinklers Systems has a return on equity of 9.7% for the last year. That means that for every ₹1 worth of shareholders’ equity, it generated ₹0.097 in profit.
Check out our latest analysis for R M Drip and Sprinklers Systems
How Do I Calculate ROE?
The formula for ROE is:
Return on Equity = Net Profit ÷ Shareholders’ Equity
Or for R M Drip and Sprinklers Systems:
9.7% = ₹16m ÷ ₹162m (Based on the trailing twelve months to March 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. You can calculate shareholders’ equity by subtracting the company’s total liabilities from its total assets.
What Does ROE Mean?
ROE measures a company’s profitability against the profit it retains, and any outside investments. The ‘return’ is the profit 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. Clearly, then, one can use ROE to compare different companies.
Does R M Drip and Sprinklers Systems 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. The limitation of this approach is that some companies are quite different from others, even within the same industry classification. The image below shows that R M Drip and Sprinklers Systems has an ROE that is roughly in line with the machinery industry average (12%).
That’s neither particularly good, nor bad. Of course, this year’s ROE might be a product of last year’s decisions. So savvy investors often note how long the CEO has been in that position.
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 debt required for growth will boost returns, but will not impact the shareholders’ equity. In this manner the use of debt will boost ROE, even though the core economics of the business stay the same.