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 of Freedom Foods Group Limited (ASX:FNP).
Our data shows Freedom Foods Group has a return on equity of 1.7% for the last year. Another way to think of that is that for every A$1 worth of equity in the company, it was able to earn A$0.02.
How Do I Calculate Return On Equity?
The formula for return on equity is:
Return on Equity = Net Profit ÷ Shareholders' Equity
Or for Freedom Foods Group:
1.7% = AU$12m ÷ AU$671m (Based on the trailing twelve months to June 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 Mean?
ROE measures a company's profitability against the profit it retains, and any outside investments. The 'return' is the yearly profit. A higher profit will lead to a higher ROE. So, as a general rule, a high ROE is a good thing. That means ROE can be used to compare two businesses.
Does Freedom Foods Group Have A Good ROE?
Arguably the easiest way to assess company's ROE is to compare it with the average in its industry. Importantly, this is far from a perfect measure, because companies differ significantly within the same industry classification. As shown in the graphic below, Freedom Foods Group has a lower ROE than the average (6.0%) in the Food industry classification.
That's not what we like to see. It is better when the ROE is above industry average, but a low one doesn't necessarily mean the business is overpriced. Nonetheless, it might be wise to check if insiders have been selling.
The Importance Of Debt To Return On Equity
Most companies need money -- from somewhere -- 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 debt used for growth will improve returns, but won't affect the total equity. That will make the ROE look better than if no debt was used.
Freedom Foods Group's Debt And Its 1.7% ROE
Although Freedom Foods Group does use debt, its debt to equity ratio of 0.17 is still low. Its ROE is certainly on the low side, and since it already uses debt, we're not too excited about the company. Conservative use of debt to boost returns is usually a good move for shareholders, though it does leave the company more exposed to interest rate rises.
The Key Takeaway
Return on equity is useful for comparing the quality of different businesses. Companies that can achieve high returns on equity without too much debt are generally of good quality. All else being equal, a higher ROE is better.
But when a business is high quality, the market often bids it up to a price that reflects this. 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 check this FREE visualization of analyst forecasts for the company.
But note: Freedom Foods Group 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.
We aim to bring you long-term focused research analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material.
If you spot an error that warrants correction, please contact the editor at firstname.lastname@example.org. 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. Thank you for reading.