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. To keep the lesson grounded in practicality, we’ll use ROE to better understand D.P. Wires Limited (NSE:DPWIRES).
Our data shows D.P. Wires has a return on equity of 15% for the last year. One way to conceptualize this, is that for each ₹1 of shareholders’ equity it has, the company made ₹0.15 in profit.
See our latest analysis for D.P. Wires
How Do You Calculate ROE?
The formula for ROE is:
Return on Equity = Net Profit ÷ Shareholders’ Equity
Or for D.P. Wires:
15% = 98.261309 ÷ ₹646m (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 the capital paid in by shareholders, plus any retained earnings. Shareholders’ equity can be calculated by subtracting the total liabilities of the company from the total assets of the company.
What Does Return On Equity Signify?
ROE measures a company’s profitability against the profit it retains, and any outside investments. The ‘return’ is the yearly profit. 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. That means ROE can be used to compare two businesses.
Does D.P. Wires Have A Good ROE?
By comparing a company’s ROE with its industry average, we can get a quick measure of how good it is. However, this method is only useful as a rough check, because companies do differ quite a bit within the same industry classification. As you can see in the graphic below, D.P. Wires has a higher ROE than the average (12%) in the Metals and Mining industry.
That is a good sign. I usually take a closer look when a company has a better ROE than industry peers. For example you might check if insiders are buying shares.
How Does Debt Impact Return On Equity?
Most companies need money — from somewhere — to grow their profits. The cash for investment can come from prior year profits (retained earnings), issuing new shares, or borrowing. 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.
D.P. Wires’s Debt And Its 15% ROE
While D.P. Wires does have a tiny amount of debt, with debt to equity of just 0.097, we think the use of debt is very modest. I’m not impressed with its ROE, but the debt levels are not too high, indicating the business has decent prospects. Judicious use of debt to improve returns can certainly be a good thing, although it does elevate risk slightly and reduce future optionality.