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 Chambal Fertilisers and Chemicals Limited (NSE:CHAMBLFERT), by way of a worked example.
Our data shows Chambal Fertilisers and Chemicals has a return on equity of 20% for the last year. One way to conceptualize this, is that for each ₹1 of shareholders’ equity it has, the company made ₹0.20 in profit.
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How Do You Calculate ROE?
The formula for ROE is:
Return on Equity = Net Profit ÷ Shareholders’ Equity
Or for Chambal Fertilisers and Chemicals:
20% = 4951.675 ÷ ₹24b (Based on the trailing twelve months to March 2018.)
Most readers would understand what net profit is, but it’s worth explaining the concept of shareholders’ equity. It is all the money paid into the company from shareholders, plus any earnings retained. Shareholders’ equity can be calculated by subtracting the total liabilities of the company from the total assets of the company.
What Does ROE Signify?
ROE looks at the amount a company earns relative to the money it has kept within the business. The ‘return’ is the profit over the last twelve months. The higher the ROE, the more profit the company is making. So, all else equal, investors should like a high ROE. Clearly, then, one can use ROE to compare different companies.
Does Chambal Fertilisers and Chemicals 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. However, this method is only useful as a rough check, because companies do differ quite a bit within the same industry classification. Pleasingly, Chambal Fertilisers and Chemicals has a superior ROE than the average (13%) company in the Chemicals industry.
That’s what I like to see. We think a high ROE, alone, is usually enough to justify further research into a company. For example, I often check if insiders have been buying shares .
How Does Debt Impact Return On Equity?
Virtually all companies need money to invest in the business, to grow profits. That cash can come from issuing shares, retained earnings, 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 use of debt will improve the returns, but will not change the equity. In this manner the use of debt will boost ROE, even though the core economics of the business stay the same.
Chambal Fertilisers and Chemicals’s Debt And Its 20% ROE
It’s worth noting the significant use of debt by Chambal Fertilisers and Chemicals, leading to its debt to equity ratio of 2.51. while its ROE is respectable, it is worth keeping in mind that there is usually a limit to how much debt a company can use. Debt increases risk and reduces options for the company in the future, so you generally want to see some good returns from using it.
The Bottom Line On ROE
Return on equity is useful for comparing the quality of different businesses. 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. Profit growth rates, versus the expectations reflected in the price of the stock, are a particularly important to consider. So you might want to check this FREE visualization of analyst forecasts for the company.
Of course Chambal Fertilisers and Chemicals 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.
To help readers see past the short term volatility of the financial market, we aim to bring you a long-term focused research analysis purely driven by fundamental data. Note that our analysis does not factor in the latest price-sensitive company announcements.
The author is an independent contributor and at the time of publication had no position in the stocks mentioned. For errors that warrant correction please contact the editor at firstname.lastname@example.org.