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 Ashok Leyland Limited (NSE:ASHOKLEY), by way of a worked example.
Return on Equity or ROE is a test of how effectively a company is growing its value and managing investors’ money. Put another way, it reveals the company's success at turning shareholder investments into profits.
Our analysis indicates that ASHOKLEY is potentially overvalued!
How To Calculate Return On Equity?
Return on equity can be calculated by using the formula:
Return on Equity = Net Profit (from continuing operations) ÷ Shareholders' Equity
So, based on the above formula, the ROE for Ashok Leyland is:
3.1% = ₹2.6b ÷ ₹84b (Based on the trailing twelve months to September 2022).
The 'return' is the income the business earned over the last year. One way to conceptualize this is that for each ₹1 of shareholders' capital it has, the company made ₹0.03 in profit.
Does Ashok Leyland Have A Good ROE?
Arguably the easiest way to assess company's ROE is to compare it with the average in 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, Ashok Leyland has a lower ROE than the average (13%) in the Machinery industry.
That certainly isn't ideal. However, a low ROE is not always bad. If the company's debt levels are moderate to low, then there's still a chance that returns can be improved via the use of financial leverage. A high debt company having a low ROE is a different story altogether and a risky investment in our books. To know the 4 risks we have identified for Ashok Leyland visit our risks dashboard for free.
How Does Debt Impact ROE?
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 required for growth will boost returns, but will not impact the shareholders' equity. That will make the ROE look better than if no debt was used.
Ashok Leyland's Debt And Its 3.1% ROE
It appears that Ashok Leyland makes extensive use of debt to improve its returns, because it has an alarmingly high debt to equity ratio of 3.16. We consider it to be a negative sign when a company has a rather low ROE despite a rather high debt to equity.
Return on equity is a useful indicator of the ability of a business to generate profits and return them to shareholders. In our books, the highest quality companies have high return on equity, despite low debt. All else being equal, a higher ROE is better.
But ROE is just one piece of a bigger puzzle, since high quality businesses often trade on high multiples of earnings. The rate at which profits are likely to grow, relative to the expectations of profit growth reflected in the current price, must be considered, too. You can see how the company has grow in the past by looking at this FREE detailed graph of past earnings, revenue and cash flow.
Of course Ashok Leyland may not be the best stock to buy. So you may wish to see this free collection of other companies that have high ROE and low debt.
Valuation is complex, but we're helping make it simple.
Find out whether Ashok Leyland is potentially over or undervalued by checking out our comprehensive analysis, which includes fair value estimates, risks and warnings, dividends, insider transactions and financial health.View the Free Analysis
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This article by Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any stocks mentioned.