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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). To keep the lesson grounded in practicality, we'll use ROE to better understand Ansell Limited (ASX:ANN).
Our data shows Ansell has a return on equity of 8.3% for the last year. One way to conceptualize this, is that for each A$1 of shareholders' equity it has, the company made A$0.083 in profit.
How Do You Calculate ROE?
The formula for return on equity is:
Return on Equity = Net Profit ÷ Shareholders' Equity
Or for Ansell:
8.3% = US$112m ÷ US$1.4b (Based on the trailing twelve months to December 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, as a general rule, a high ROE is a good thing. That means ROE can be used to compare two businesses.
Does Ansell 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. If you look at the image below, you can see Ansell has a lower ROE than the average (11%) in the Medical Equipment industry classification.
Unfortunately, that's sub-optimal. It is better when the ROE is above industry average, but a low one doesn't necessarily mean the business is overpriced. Nonetheless, it could be useful to double-check if insiders have sold shares recently.
Why You Should Consider Debt When Looking At ROE
Companies usually need to invest money to grow their profits. The cash for investment can come from prior year profits (retained earnings), issuing new shares, or borrowing. 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.
Ansell's Debt And Its 8.3% ROE
Ansell has a debt to equity ratio of 0.40, which is far from excessive. I'm not impressed with its ROE, but the debt levels are not too high, indicating the business has decent prospects. Judicious use of debt to improve returns can certainly be a good thing, although it does elevate risk slightly and reduce future optionality.
But It's Just One Metric
Return on equity is one way we can compare the business quality of different companies. A company that can achieve a high return on equity without debt could be considered a high quality business. If two companies have the same ROE, then I would generally prefer the one with less debt.
But ROE is just one piece of a bigger puzzle, since high quality businesses often trade on high multiples of earnings. 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.
If you would prefer check out another company -- one with potentially superior financials -- then do not miss this free list of interesting companies, that have HIGH return on equity 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 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. Thank you for reading.