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. We'll use ROE to examine Nelco Limited (NSE:NELCO), 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.
View our latest analysis for Nelco
How Do You Calculate Return On Equity?
The formula for ROE is:
Return on Equity = Net Profit (from continuing operations) ÷ Shareholders' Equity
So, based on the above formula, the ROE for Nelco is:
22% = ₹144m ÷ ₹659m (Based on the trailing twelve months to March 2020).
The 'return' is the income the business earned over the last year. Another way to think of that is that for every ₹1 worth of equity, the company was able to earn ₹0.22 in profit.
Does Nelco Have A Good Return On Equity?
By comparing a company's ROE with its industry average, we can get a quick measure of how good it is. The limitation of this approach is that some companies are quite different from others, even within the same industry classification. Pleasingly, Nelco has a superior ROE than the average (8.8%) in the Communications industry.
That's what we like to see. Bear in mind, a high ROE doesn't always mean superior financial performance. Aside from changes in net income, a high ROE can also be the outcome of high debt relative to equity, which indicates risk. You can see the 5 risks we have identified for Nelco by visiting our risks dashboard for free on our platform here.
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 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.
Nelco's Debt And Its 22% ROE
It's worth noting the high use of debt by Nelco, leading to its debt to equity ratio of 1.49. While its ROE is respectable, it is worth keeping in mind that there is usually a limit as 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.
Summary
Return on equity is one way we can compare its business quality of different companies. Companies that can achieve high returns on equity without too much debt are generally of good quality. 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 ROE is just one piece of a bigger puzzle, since high quality businesses often trade on high multiples of earnings. Profit growth rates, versus the expectations reflected in the price of the stock, are a particularly important to consider. 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 Nelco 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.
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About NSEI:NELCO
Nelco
Provides systems and solutions in the areas of very small aperture terminals (VSAT) connectivity, and integrated security and surveillance in India.
Flawless balance sheet with questionable track record.