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. We’ll use ROE to examine Pansari Developers Limited (NSE:PANSARI), by way of a worked example.
Pansari Developers has a ROE of 5.8%, based on the last twelve months. One way to conceptualize this, is that for each ₹1 of shareholders’ equity it has, the company made ₹0.058 in profit.
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How Do You Calculate Return On Equity?
The formula for ROE is:
Return on Equity = Net Profit ÷ Shareholders’ Equity
Or for Pansari Developers:
5.8% = ₹32m ÷ ₹552m (Based on the trailing twelve months to March 2018.)
Most know that net profit is the total earnings after all expenses, but the concept of shareholders’ equity is a little more complicated. It is all earnings retained by the company, plus any capital paid in by shareholders. The easiest way to calculate shareholders’ equity is to subtract the company’s total liabilities from the total assets.
What Does Return On Equity 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. A higher profit will lead to a a higher ROE. So, all else equal, investors should like a high ROE. Clearly, then, one can use ROE to compare different companies.
Does Pansari Developers 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. Importantly, this is far from a perfect measure, because companies differ significantly within the same industry classification. As you can see in the graphic below, Pansari Developers has a higher ROE than the average (3.6%) in the real estate industry.
That’s clearly a positive. In my book, a high ROE almost always warrants a closer look. For example, I often check if insiders have been buying shares .
How Does Debt Impact Return On Equity?
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 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.
Pansari Developers’s Debt And Its 5.8% ROE
It’s worth noting the significant use of debt by Pansari Developers, leading to its debt to equity ratio of 1.17. Its ROE is quite low, even with the use of significant debt; that’s not a good result, in my opinion. Debt increases risk and reduces options for the company in the future, so you generally want to see some good returns from using it.