While some investors are already well versed in financial metrics (hat tip),bmx bikes for teens 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 PNC Infratech Limited (

NSE:PNCINFRA

), by way of a worked example.

Our data shows

PNC Infratech has a return on equity of 14%

for the last year. One way to conceptualize this, is that for each ₹1 of shareholders’ equity it has, the company made ₹0.14 in profit.

See our latest analysis for PNC Infratech

How Do You Calculate Return On Equity?

The

formula for return on equity

is:

Return on Equity = Net Profit ÷ Shareholders’ Equity

Or for PNC Infratech:

14% = 2430.076 ÷ ₹17b (Based on the trailing twelve months to March 2018.)

Most readers would understand what net profit is, but it’s worth explaining the concept of shareholders’ equity. It is the capital paid in by shareholders, plus any retained earnings. The easiest way to calculate shareholders’ equity is to subtract the company’s total liabilities from the 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 profit over the last twelve months. 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 it can be interesting to compare the ROE of different companies.

Does PNC Infratech Have A Good Return On Equity?

Arguably the easiest way to assess company’s ROE is to compare it with the average in 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, PNC Infratech has a higher ROE than the average (8.7%) in the Construction industry.

NSEI:PNCINFRA Last Perf January 3rd 19

That’s clearly a positive. We think a high ROE, alone, is usually enough to justify further research into a company. One data point to check is if

insiders have bought shares recently

.

How Does Debt Impact Return On Equity?

Companies usually need to invest money to grow their profits. That cash can come from retained earnings, issuing new shares (equity), 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. In this manner the use of debt will boost ROE, even though the core economics of the business stay the same.

PNC Infratech’s Debt And Its 14% ROE

PNC Infratech clearly uses a significant amount debt to boost returns, as it has a debt to equity ratio of 1.20. While the ROE isn’t too bad, it would probably be a lot lower if the company was forced to reduce debt. Debt does bring extra risk, so it’s only really worthwhile when a company generates some decent returns from it.

Story continues

In Summary

Return on equity is a useful indicator of the ability of a business to generate profits and return them to shareholders. In my book the highest quality companies have high return on equity, despite low debt. If two companies have around the same level of debt to equity, and one has a higher ROE, I’d generally prefer the one with higher ROE.

Having said that, while ROE is a useful indicator of business quality, you’ll have to look at a whole range of factors to determine the right price to buy a stock. The rate at which profits are likely to grow, relative to the expectations of profit growth reflected in the current price, must be considered, too. So you might want to take a peek at this

data-rich interactive graph of forecasts for the company

.

Of course

PNC Infratech 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]

.

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