One of the best investments we can make is in our own knowledge and skill set. With that in mind, this article will work through how we can use Return On Equity (ROE) to better understand a business. By way of learning-by-doing, we’ll look at ROE to gain a better understanding Public Joint Stock Company Uralkali (MCX:URKA).
Over the last twelve months Uralkali has recorded a ROE of 43%. That means that for every RUB1 worth of shareholders’ equity, it generated RUB0.43 in profit.
How Do You Calculate Return On Equity?
The formula for return on equity is:
Return on Equity = Net Profit ÷ Shareholders’ Equity
Or for Uralkali:
43% = 424.155 ÷ US$989m (Based on the trailing twelve months to June 2018.)
Most readers would understand what net profit is, but it’s worth explaining the concept of shareholders’ equity. It is all the money paid into the company from shareholders, plus any earnings retained. The easiest way to calculate shareholders’ equity is to subtract the company’s total liabilities from the total assets.
What Does Return On Equity 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. That means that the higher the ROE, the more profitable the company is. So, all else being equal, a high ROE is better than a low one. That means ROE can be used to compare two businesses.
Does Uralkali Have A Good ROE?
By comparing a company’s ROE with its industry average, we can get a quick measure of how good it is. 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, Uralkali has a better ROE than the average (21%) in the chemicals industry.
That’s clearly a positive. I usually take a closer look when a company has a better ROE than industry peers. One data point to check is if insiders have bought shares recently.
How Does Debt Impact Return On Equity?
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 use of debt will improve the returns, but will not change the equity. That will make the ROE look better than if no debt was used.
Combining Uralkali’s Debt And Its 43% Return On Equity
We think Uralkali uses a lot of debt to boost returns, as it has a relatively high debt to equity ratio of 6.21. Its ROE is clearly quite good, but it would probably be significantly lower without all the debt.
The Key Takeaway
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 the same ROE, then I would generally prefer the one with less debt.
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. Check the past profit growth by Uralkali by looking at this visualization of past earnings, revenue and cash flow.
But note: Uralkali may not be the best stock to buy. So take a peek at this free list of interesting companies with 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 firstname.lastname@example.org.