Many investors are still learning about the various metrics that can be useful when analysing a stock. This article is for those who would like to learn about Return On Equity (ROE). By way of learning-by-doing, weāll look at ROE to gain a better understanding ICICI Prudential Life Insurance Company Limited (NSE:ICICIPRULI).
Over the last twelve months ICICI Prudential Life Insurance has recorded a ROE of 27%. Another way to think of that is that for every ā¹1 worth of equity in the company, it was able to earn ā¹0.27.
The formula for return on equity is:
Return on Equity = Net Profit Ć· Shareholdersā Equity
Or for ICICI Prudential Life Insurance:
27% = ā¹17.7b Ć· ā¹66.2b (Based on the trailing twelve months to June 2018.)
Most readers would understand what net profit is, but itās worth explaining the concept of shareholdersā equity. It is the capital paid in by shareholders, plus any retained earnings. You can calculate shareholdersā equity by subtracting the companyās total liabilities from its total assets.
ROE measures a companyās profitability against the profit it retains, and any outside investments. The āreturnā 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.
One simple way to determine if a company has a good return on equity is to compare it to the average for its industry. The limitation of this approach is that some companies are quite different from others, even within the same industry classification. As you can see in the graphic below, ICICI Prudential Life Insurance has a higher ROE than the average (16%) in the insurance industry.
Thatās clearly a positive. I usually take a closer look when a company has a better ROE than industry peers. For example, I often check if insiders have been buying shares .
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 case of the first and second options, the ROE will reflect this use of cash, for growth. In the latter case, the debt required for growth will boost returns, but will not impact the shareholdersā equity. Thus the use of debt can improve ROE, albeit along with extra risk in the case of stormy weather, metaphorically speaking.
One positive for shareholders is that ICICI Prudential Life Insurance does not have any net debt! Its ROE suggests it is a decent business; and the fact it is not leveraging returns indicates it is well worth watching. After all, when a company has a strong balance sheet, it can often find ways to invest in growth, even if it takes some time.
Return on equity is a useful indicator of the ability of a business to generate profits and return them to shareholders. A company that can achieve a high return on equity without debt could be considered a high quality business. If two companies have around the same level of debt to equity, and one has a higher ROE, Iād generally prefer the one with higher ROE.
But when a business is high quality, the market often bids it up to a price that reflects this. Profit growth rates, versus the expectations reflected in the price of the stock, are a particularly important to consider. So you might want to take a peek at this data-rich interactive graph of forecasts for the company.
Of course ICICI Prudential Life Insurance may not be the best stock to buy. So you may wish to see this free collection of other companies that have high ROE and low debt.
To help readers see past the short term volatility of the financial market, we aim to bring you a long-term focused research analysis purely driven by fundamental data. Note that our analysis does not factor in the latest price-sensitive company announcements.
The author is an independent contributor and at the time of publication had no position in the stocks mentioned. For errors that warrant correction please contact the editor at [email protected].
Noted activist shareholder, Carl Ichan has become famous (and rich) by taking positions in badly run public corporations and forcing them to make radical changes to uncover shareholders value. “Icahn lift” is a bump in a company’s stock price that often occurs after he has taken a position in it. What were his last buys? Click here to view a FREE detailed infographic analysis of Carl Icahnās investment portfolio.