While some investors are already familiar with financial metrics (hat tip), this article is for those who want to learn more about return on equity (ROE) and why it is important. To keep the lesson grounded in practicality, we will use ROE to better understand The Anup Engineering Limited (NSE: ANUP).
Return on equity or ROE is a test of how effectively a company increases its value and manages investor money. In short, ROE shows the profit that each dollar generates compared to the investments of its shareholders.
Check out our latest review for Anup Engineering
How is the ROE calculated?
ROE can be calculated using the formula:
Return on equity = Net income (from continuing operations) ÷ Equity
Thus, based on the above formula, Anup Engineering’s ROE is:
16% = ₹ 535m ÷ ₹ 3.4 billion (based on the last twelve months to March 2021).
The “return” is the annual profit. So this means that for every ₹ 1 of its shareholder’s investments, the company generates a profit of ₹ 0.16.
Does Anup Engineering have a good return on equity?
Perhaps the easiest way to assess a company’s ROE is to compare it to the industry average. Importantly, this is far from a perfect measure, as companies differ considerably within a single industry classification. Fortunately, Anup Engineering has an above average ROE (9.8%) in the machinery industry.
This is what we love to see. Keep in mind that a high ROE doesn’t always mean superior financial performance. A higher proportion of debt in a company’s capital structure can also result in high ROE, where high debt levels can represent a huge risk.
How Does Debt Affect Return on Equity?
Most businesses need money – from somewhere – to grow their profits. The money to invest can come from the previous year’s profits (retained earnings), from the issuance of new shares, or from 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 used for growth will improve returns, but will not affect total equity. In this way, the use of debt will increase the ROE, even if the basic economy of the business remains the same.
Anup Engineering’s debt and its 16% ROE
A positive point for shareholders is that Anup Engineering has no net debt! Its ROE suggests it’s a decent business; and the fact that it is not leveraging returns indicates that it is worth watching. After all, with cash on the balance sheet, a business has many more options in good times and bad.
Return on equity is useful for comparing the quality of different companies. A business that can earn a high return on equity without debt could be considered a high quality business. All other things being equal, a higher ROE is preferable.
That said, while ROE is a useful indicator of how good a business is, you will need to look at a variety of factors to determine the right price to buy a stock. Especially important to consider are the growth rates of earnings, relative to expectations reflected in the share price. You might want to check out this FREE visualization of analyst forecasts for the business.
Of course, you might find a fantastic investment looking elsewhere. So take a look at this free list of interesting companies.
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