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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 Chambal Fertilisers and Chemicals Limited (NSE:CHAMBLFERT).
Chambal Fertilisers and Chemicals has a ROE of 21%, 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 ₹0.21.
View our latest analysis for Chambal Fertilisers and Chemicals
How Do You Calculate ROE?
The formula for return on equity is:
Return on Equity = Net Profit ÷ Shareholders' Equity
Or for Chambal Fertilisers and Chemicals:
21% = ₹5.9b ÷ ₹28b (Based on the trailing twelve months to March 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. The easiest way to calculate shareholders' equity is to subtract the company's total liabilities from the total assets.
What Does ROE Signify?
ROE looks at the amount a company earns relative to the money it has kept within the business. The 'return' is the amount earned after tax over the last twelve months. 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 Chambal Fertilisers and Chemicals Have A Good ROE?
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, Chambal Fertilisers and Chemicals has a higher ROE than the average (13%) in the Chemicals industry.
That is a good sign. 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?
Companies usually need to invest money 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. Thus the use of debt can improve ROE, albeit along with extra risk in the case of stormy weather, metaphorically speaking.