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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. We will use ROE to examine Larsen & Toubro Limited (NSE: LT), through a worked example.
Return on equity or ROE is an important factor for a shareholder to consider because it tells them how effectively their capital is being reinvested. Simply put, it is used to assess a company’s profitability against its equity.
See our latest analysis for Larsen & Toubro
How do you calculate return on equity?
ROE can be calculated using the formula:
Return on equity = Net income (from continuing operations) ÷ Equity
Thus, on the basis of the above formula, the ROE of Larsen & Toubro is:
6.5% = ₹ 57b ÷ ₹ 879b (Based on the last twelve months up to June 2021).
The “return” is the income the business has earned over the past year. This means that for every having shareholders, the company generated ₹ 0.06 in profit.
Do Larsen & Toubro have a good ROE?
Perhaps the easiest way to assess a company’s ROE is to compare it to the industry average. It is important to note that this measure is far from perfect, as companies differ considerably within a single industry classification. You can see from the graph below that Larsen & Toubro has a ROE quite close to the Construction sector average (7.7%).
So even if the ROE is not exceptional, it is at least acceptable. Even though the ROE is respectable compared to the industry, it is worth checking out if the company’s ROE is helped by high debt levels. If so, it increases their exposure to financial risk. Our risk dashboard should include the 5 risks that we have identified for Larsen & Toubro.
The importance of debt to return on equity
Most businesses need money – from somewhere – to increase their profits. This liquidity can come from retained earnings, the issuance of new shares (shares) 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 debt used for growth will improve returns, but will not affect total equity. This will make the ROE better than if no debt was used.
Larsen & Toubro’s debt and its ROE of 6.5%
Note the strong recourse to debt by Larsen & Toubro, leading to a debt / equity ratio of 1.53. With a fairly low ROE and heavy use of debt, it’s hard to get excited about this business right now. Investors should think carefully about how a business will perform if it weren’t able to borrow so easily, as credit markets change over time.
Conclusion
Return on equity is a way to compare the quality of the business of different companies. A business that can earn a high return on equity without going into debt could be considered a high quality business. If two companies have the same ROE, then 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. Especially important to consider are the growth rates of earnings, relative to expectations reflected in the share price. So you might want to check out this FREE visualization of analyst forecasts for the business.
If you would rather consult with another company – one with potentially superior finances – then don’t miss this free list of interesting companies, which have a HIGH return on equity and low leverage.
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 shares 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.
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