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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. We'll use ROE to examine JK Paper Limited (NSE:JKPAPER), by way of a worked example.
Our data shows JK Paper has a return on equity of 20% for the last year. One way to conceptualize this, is that for each ₹1 of shareholders' equity it has, the company made ₹0.20 in profit.
See our latest analysis for JK Paper
How Do I Calculate ROE?
The formula for return on equity is:
Return on Equity = Net Profit ÷ Shareholders' Equity
Or for JK Paper:
20% = ₹4.3b ÷ ₹21b (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. You can calculate shareholders' equity by subtracting the company's total liabilities from its total assets.
What Does ROE Mean?
Return on Equity measures a company's profitability against the profit it has kept for the business (plus any capital injections). 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 JK Paper 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, JK Paper has a better ROE than the average (12%) in the Forestry industry.
That's clearly a positive. We think a high ROE, alone, is usually enough to justify further research into a company. 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. That cash can come from retained earnings, issuing new shares (equity), or debt. 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 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.
Combining JK Paper's Debt And Its 20% Return On Equity
While JK Paper does have some debt, with debt to equity of just 0.62, we wouldn't say debt is excessive. The combination of modest debt and a very respectable ROE suggests this is a business worth watching. Judicious use of debt to improve returns can certainly be a good thing, although it does elevate risk slightly and reduce future optionality.