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. To keep the lesson grounded in practicality, we’ll use ROE to better understand Gulf Oil Lubricants India Limited (NSE:GULFOILLUB).
Our data shows Gulf Oil Lubricants India has a return on equity of 32% for the last year. One way to conceptualize this, is that for each ₹1 of shareholders’ equity it has, the company made ₹0.32 in profit.
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How Do You Calculate Return On Equity?
The formula for return on equity is:
Return on Equity = Net Profit ÷ Shareholders’ Equity
Or for Gulf Oil Lubricants India:
32% = 1642.711 ÷ ₹5.1b (Based on the trailing twelve months to September 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. The easiest way to calculate shareholders’ equity is to subtract the company’s total liabilities from the 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 amount earned after tax 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. Clearly, then, one can use ROE to compare different companies.
Does Gulf Oil Lubricants India 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 is clear from the image below, Gulf Oil Lubricants India has a better ROE than the average (13%) in the Chemicals industry.
That is a good sign. In my book, a high ROE almost always warrants a closer look. For example, I often check if insiders have been buying shares .
The Importance Of Debt To Return On Equity
Virtually all companies need money to invest in the business, to grow profits. That cash can come from retained earnings, issuing new shares (equity), or debt. In the case of the first and second options, the ROE will reflect this use of cash, for growth. 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.
Combining Gulf Oil Lubricants India’s Debt And Its 32% Return On Equity
While Gulf Oil Lubricants India does have some debt, with debt to equity of just 0.61, we wouldn’t say debt is excessive. The combination of modest debt and a very impressive ROE does suggest that the business is high quality. Judicious use of debt to improve returns can certainly be a good thing, although it does elevate risk slightly and reduce future optionality.
Return on equity is one way we can compare the business quality of different companies. A company that can achieve a high return on equity without debt could be considered a high quality business. If two companies have the same ROE, then I would generally prefer the one with less debt.
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.
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.