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While some investors are already well versed in financial metrics (hat tip), this article is for those who would like to learn about Return On Equity (ROE) and why it is important. We'll use ROE to examine MIND C.T.I. Ltd (NASDAQ:MNDO), by way of a worked example.
Our data shows MIND C.T.I has a return on equity of 24% for the last year. That means that for every $1 worth of shareholders' equity, it generated $0.24 in profit.
How Do I Calculate Return On Equity?
The formula for ROE is:
Return on Equity = Net Profit ÷ Shareholders' Equity
Or for MIND C.T.I:
24% = US$5.1m ÷ US$21m (Based on the trailing twelve months to December 2018.)
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 all earnings retained by the company, plus any capital paid in by shareholders. 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 profit over the last twelve months. That means that the higher the ROE, the more profitable the company is. So, all else being equal, a high ROE is better than a low one. That means it can be interesting to compare the ROE of different companies.
Does MIND C.T.I 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. Pleasingly, MIND C.T.I has a superior ROE than the average (11%) company in the Software industry.
That is a good sign. I usually take a closer look when a company has a better ROE than industry peers. For example you might check if insiders are buying shares.
The Importance Of Debt To Return On Equity
Virtually all companies need money to invest in the business, to grow profits. That cash can come from issuing shares, retained earnings, or debt. In the case of the first and second options, the ROE will reflect this use of cash, for growth. In the latter case, the debt used for growth will improve returns, but won't affect the total equity. In this manner the use of debt will boost ROE, even though the core economics of the business stay the same.
Combining MIND C.T.I's Debt And Its 24% Return On Equity
One positive for shareholders is that MIND C.T.I does not have any net debt! Its high ROE indicates the business is high quality, but the fact that this was achieved without leverage is veritably impressive. At the end of the day, when a company has zero debt, it is in a better position to take future growth opportunities.
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. If two companies have the same ROE, then I would generally prefer the one with less debt.
But when a business is high quality, the market often bids it up to a price that reflects this. Profit growth rates, versus the expectations reflected in the price of the stock, are a particularly important to consider. You can see how the company has grow in the past by looking at this FREE detailed graph of past earnings, revenue and cash flow.
But note: MIND C.T.I 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 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.