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Is Ecofibre Limited's (ASX:EOF) 14% ROE Better Than Average?

Simply Wall St

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 Ecofibre Limited (ASX:EOF), by way of a worked example.

Our data shows Ecofibre has a return on equity of 14% 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$0.14.

See our latest analysis for Ecofibre

How Do You Calculate ROE?

The formula for ROE is:

Return on Equity = Net Profit ÷ Shareholders' Equity

Or for Ecofibre:

14% = AU$6.0m ÷ AU$42m (Based on the trailing twelve months to June 2019.)

Most know that net profit is the total earnings after all expenses, but the concept of shareholders' equity is a little more complicated. It is the capital paid in by shareholders, plus any retained earnings. Shareholders' equity can be calculated by subtracting the total liabilities of the company from the total assets of the company.

What Does ROE Mean?

ROE measures a company's profitability against the profit it retains, and any outside investments. The 'return' is the yearly profit. 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 it can be interesting to compare the ROE of different companies.

Does Ecofibre Have A Good Return On Equity?

By comparing a company's ROE with its industry average, we can get a quick measure of how good it is. The limitation of this approach is that some companies are quite different from others, even within the same industry classification. As you can see in the graphic below, Ecofibre has a higher ROE than the average (7.7%) in the Pharmaceuticals industry.

ASX:EOF Past Revenue and Net Income, October 31st 2019

That's what I like to see. We think a high ROE, alone, is usually enough to justify further research into a company. For example, I often check if insiders have been buying shares.

Why You Should Consider Debt When Looking At 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 case of the first and second options, the ROE will reflect this use of cash, for growth. In the latter case, the use of debt will improve the returns, but will not change the equity. In this manner the use of debt will boost ROE, even though the core economics of the business stay the same.

Ecofibre's Debt And Its 14% ROE

Although Ecofibre does use a little debt, its debt to equity ratio of just 0.032 is very low. Its very respectable ROE, combined with only modest debt, suggests the business is in good shape. Careful use of debt to boost returns is often very good for shareholders. However, it could reduce the company's ability to take advantage of future opportunities.

The Bottom Line On ROE

Return on equity is a useful indicator of the ability of a business to generate profits and return them to shareholders. Companies that can achieve high returns on equity without too much debt are generally of good quality. 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.

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. Check the past profit growth by Ecofibre by looking at this visualization of past earnings, revenue and cash flow.

Of course, you might find a fantastic investment by looking elsewhere. So take a peek at this free list of interesting companies.

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 editorial-team@simplywallst.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.