While some investors are already well versed in financial metrics (hat tip), this article is for those who would like to learn about Return On Equity (ROE) and why it is important. By way of learning-by-doing, we’ll look at ROE to gain a better understanding of Endurance Technologies Limited (NSE:ENDURANCE).
Over the last twelve months Endurance Technologies has recorded a ROE of 21%. Another way to think of that is that for every ₹1 worth of equity in the company, it was able to earn ₹0.21.
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How Do I Calculate ROE?
The formula for ROE is:
Return on Equity = Net Profit (from continuing operations) ÷ Shareholders’ Equity
Or for Endurance Technologies:
21% = ₹5.8b ÷ ₹28b (Based on the trailing twelve months to September 2019.)
It’s easy to understand the ‘net profit’ part of that equation, but ‘shareholders’ equity’ requires further explanation. It is all earnings retained by the company, plus any capital paid in by shareholders. 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 profit over the last twelve months. That means that the higher the ROE, the more profitable the company is. 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 Endurance Technologies 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 you can see in the graphic below, Endurance Technologies has a higher ROE than the average (11%) in the Auto Components industry.
That’s clearly a positive. I usually take a closer look when a company has a better ROE than industry peers. For example you might check if insiders are buying shares.
The Importance Of Debt To Return On Equity
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. That will make the ROE look better than if no debt was used.
Combining Endurance Technologies’s Debt And Its 21% Return On Equity
Endurance Technologies has a debt to equity ratio of 0.14, which is far from excessive. Its very respectable ROE, combined with only modest debt, suggests the business is in good shape. Judicious use of debt to improve returns can certainly be a good thing, although it does elevate risk slightly and reduce future optionality.
But It’s Just One Metric
Return on equity is a useful indicator of the ability of a business to generate profits and return them to shareholders. In my book the highest quality companies have high return on equity, despite low debt. If two companies have around the same level of debt to equity, and one has a higher ROE, I’d generally prefer the one with higher ROE.
But when a business is high quality, the market often bids it up to a price that reflects this. It is important to consider other factors, such as future profit growth — and how much investment is required going forward. So I think it may be worth checking this free report on analyst forecasts for the company.
Of course, you might find a fantastic investment by looking elsewhere. So take a peek at this free list of interesting companies.
If you spot an error that warrants correction, please contact the editor at editorial-team@simplywallst.com. This article by Simply Wall St is general in nature. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. Simply Wall St has no position in the stocks mentioned.
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