In This Article:
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 eClerx Services Limited (NSE:ECLERX), by way of a worked example.
Over the last twelve months eClerx Services has recorded a ROE of 15%. One way to conceptualize this, is that for each ₹1 of shareholders' equity it has, the company made ₹0.15 in profit.
View our latest analysis for eClerx Services
How Do I Calculate Return On Equity?
The formula for ROE is:
Return on Equity = Net Profit ÷ Shareholders' Equity
Or for eClerx Services:
15% = ₹2.1b ÷ ₹14b (Based on the trailing twelve months to June 2019.)
Most readers would understand what net profit is, but it’s worth explaining the concept of shareholders’ equity. It is all earnings retained by the company, plus any capital paid in by shareholders. You can calculate shareholders' equity by subtracting the company's total liabilities from its total assets.
What Does ROE Signify?
ROE measures a company's profitability against the profit it retains, and any outside investments. The 'return' is the yearly profit. A higher profit will lead to a higher ROE. So, as a general rule, a high ROE is a good thing. That means ROE can be used to compare two businesses.
Does eClerx Services Have A Good ROE?
Arguably the easiest way to assess company's ROE is to compare it with the average in its industry. However, this method is only useful as a rough check, because companies do differ quite a bit within the same industry classification. As is clear from the image below, eClerx Services has a better ROE than the average (12%) in the IT industry.
That's what I like to see. 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.
Why You Should Consider Debt When Looking At ROE
Most companies need money -- from somewhere -- to grow their profits. That cash can come from retained earnings, issuing new shares (equity), or debt. In the first two cases, the ROE will capture this use of capital to grow. In the latter case, the debt used for growth will improve returns, but won't affect the total equity. That will make the ROE look better than if no debt was used.
eClerx Services's Debt And Its 15% ROE
Although eClerx Services does use a little debt, its debt to equity ratio of just 0.0012 is very low. Although the ROE isn't overly impressive, the debt load is modest, suggesting the business has potential. Careful use of debt to boost returns is often very good for shareholders. However, it could reduce the company's ability to take advantage of future opportunities.