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 A and M Jumbo Bags Limited (NSE:AMJUMBO), by way of a worked example.
Over the last twelve months A and M Jumbo Bags has recorded a ROE of 5.9%. Another way to think of that is that for every ₹1 worth of equity in the company, it was able to earn ₹0.059.
See our latest analysis for A and M Jumbo Bags
How Do I Calculate Return On Equity?
The formula for return on equity is:
Return on Equity = Net Profit ÷ Shareholders’ Equity
Or for A and M Jumbo Bags:
5.9% = ₹3m ÷ ₹60m (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 all the money paid into the company from shareholders, plus any earnings retained. 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 yearly profit. A higher profit will lead to a a higher ROE. So, as a general rule, a high ROE is a good thing. That means it can be interesting to compare the ROE of different companies.
Does A and M Jumbo Bags 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 shown in the graphic below, A and M Jumbo Bags has a lower ROE than the average (9.8%) in the packaging industry classification.
That certainly isn’t ideal. We’d prefer see an ROE above the industry average, but it might not matter if the company is undervalued. Nonetheless, it could be useful to double-check if insiders have sold shares recently.
The Importance Of Debt To Return On Equity
Companies usually need to invest money to grow their profits. The cash for investment can come from prior year profits (retained earnings), issuing new shares, or borrowing. 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 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.