One of the best investments we can make is in our own knowledge and skills. With that in mind, this article will discuss how we can use Return on Equity (ROE) to better understand a business. As a learning by doing, we will look at the ROE to better understand Hitachi Energy India Limited (NSE: POWERINDIA).
Return on equity or ROE is a test of how effectively a company increases its value and manages investor money. Simply put, it is used to assess a company’s profitability against its equity.
Check out our latest review for Hitachi Energy India
How is the ROE calculated?
The formula for ROE is:
Return on equity = Net income (from continuing operations) ÷ Equity
So, based on the above formula, the ROE for Hitachi Energy India is:
15% = ₹ 1.5b ÷ ₹ 9.8b (based on the last twelve months up to September 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 ₹ 0.15.
Does Hitachi Energy India have a good ROE?
By comparing a company’s ROE with its industry average, we can get a quick measure of its quality. The limitation of this approach is that some companies are very different from others, even within the same industry classification. As you can see in the graph below, Hitachi Energy India has an above-average ROE (10%) for the power industry.
It’s a good sign. However, keep in mind that a high ROE does not necessarily indicate efficient profit generation. Especially when a business uses high levels of leverage to finance its debt, which can increase its ROE, but high leverage puts the business at risk. To know the 2 risks we have identified for Hitachi Energy India, visit our free risk dashboard.
The importance of debt to return on equity
Businesses generally need to invest money to increase their profits. This liquidity can come from retained earnings, the issuance of new shares (equity) or debt. In the first and second cases, the ROE will reflect this use of cash for investing in the business. In the latter case, the use of debt will improve returns, but will not affect equity. This will make the ROE better than if no debt was used.
Hitachi Energy India’s debt and its ROE of 15%
Hitachi Energy India has a debt ratio of only 0.035, which is very low. The fact that she achieved a fairly good ROE with only modest debt suggests that the business might be worth putting on your watch list. The prudent use of debt to increase returns is generally good for shareholders, even if it leaves the company more exposed to interest rate hikes.
Return on equity is a way to compare the business quality of different companies. Firms that can earn high returns on equity without taking on too much debt are generally of good quality. If two companies have the same ROE, I would generally prefer the one with the least amount of debt.
But when a company is of high quality, the market often offers it up to a price that reflects that. The rate at which earnings are likely to grow, relative to earnings growth expectations reflected in the current price, should also be taken into account. You might want to take a look at this data-rich interactive chart of the forecast for the business.
Sure, you might find a fantastic investment looking elsewhere. So take a look at this free list of interesting companies.
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This Simply Wall St article is general in nature. We provide commentary based on historical data and analyst forecasts using only unbiased methodology and our articles are not intended to be financial advice. It does not constitute a recommendation to buy or sell any stock and does not take into account your goals or your financial situation. Our aim is to bring you long-term, targeted analysis based on fundamental data. Note that our analysis may not take into account the latest announcements from price sensitive companies or qualitative documents. Simply Wall St has no position in any of the stocks mentioned.