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. By way of learning-by-doing, we’ll look at ROE to gain a better understanding GlaxoSmithKline Consumer Healthcare Limited (NSE:GSKCONS).
GlaxoSmithKline Consumer Healthcare has a ROE of 24%, based on the last twelve months. Another way to think of that is that for every ₹1 worth of equity in the company, it was able to earn ₹0.24.
Check out our latest analysis for GlaxoSmithKline Consumer Healthcare
How Do You Calculate Return On Equity?
The formula for ROE is:
Return on Equity = Net Profit ÷ Shareholders’ Equity
Or for GlaxoSmithKline Consumer Healthcare:
24% = 8514.022 ÷ ₹36b (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 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, all else equal, investors should like a high ROE. That means ROE can be used to compare two businesses.
Does GlaxoSmithKline Consumer Healthcare 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. 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, GlaxoSmithKline Consumer Healthcare has a higher ROE than the average (9.3%) in the food industry.
That’s what I like to see. 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 first and second cases, the ROE will reflect this use of cash for investment in the business. In the latter case, the debt used for growth will improve returns, but won’t affect the total equity. In this manner the use of debt will boost ROE, even though the core economics of the business stay the same.