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). We'll use ROE to examine Atresmedia Corporación de Medios de Comunicación, S.A. (BME:A3M), by way of a worked example.
Atresmedia Corporación de Medios de Comunicación has a ROE of 19%, based on the last twelve months. That means that for every €1 worth of shareholders' equity, it generated €0.19 in profit.
How Do You Calculate ROE?
The formula for return on equity is:
Return on Equity = Net Profit (from continuing operations) ÷ Shareholders' Equity
Or for Atresmedia Corporación de Medios de Comunicación:
19% = €82m ÷ €444m (Based on the trailing twelve months to September 2019.)
It's easy to understand the 'net profit' part of that equation, but 'shareholders' equity' requires further explanation. It is the capital paid in by shareholders, plus any retained earnings. You can calculate shareholders' equity by subtracting the company's total liabilities from its total assets.
What Does Return On Equity Signify?
ROE measures a company's profitability against the profit it retains, and any outside investments. The 'return' is the profit over the last twelve months. A higher profit will lead to a higher ROE. So, all else equal, investors should like a high ROE. Clearly, then, one can use ROE to compare different companies.
Does Atresmedia Corporación de Medios de Comunicación Have A Good ROE?
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 is clear from the image below, Atresmedia Corporación de Medios de Comunicación has a better ROE than the average (10%) in the Media industry.
That is a good sign. 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 ROE?
Virtually all companies need money to invest in the business, to grow profits. The cash for investment can come from prior year profits (retained earnings), issuing new shares, or borrowing. In the first and second cases, the ROE will reflect this use of cash for investment in the business. 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 Atresmedia Corporación de Medios de Comunicación's Debt And Its 19% Return On Equity
While Atresmedia Corporación de Medios de Comunicación does have some debt, with debt to equity of just 0.65, we wouldn't say debt is excessive. The fact that it achieved a fairly good ROE with only modest debt suggests the business might be worth putting on your watchlist. Judicious use of debt to improve returns can certainly be a good thing, although it does elevate risk slightly and reduce future optionality.
Return on equity is one way we can compare the business quality of different companies. 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. 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, you might find a fantastic investment by looking elsewhere. So take a peek at this free list of interesting companies.
If you spot an error that warrants correction, please contact the editor at email@example.com. This article by Simply Wall St is general in nature. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. Simply Wall St has no position in the stocks mentioned.
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