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. We'll use ROE to examine Stille AB (STO:STIL), by way of a worked example.
Stille has a ROE of 25%, based on the last twelve months. One way to conceptualize this, is that for each SEK1 of shareholders' equity it has, the company made SEK0.25 in profit.
How Do I Calculate ROE?
The formula for return on equity is:
Return on Equity = Net Profit (from continuing operations) ÷ Shareholders' Equity
Or for Stille:
25% = kr24m ÷ kr98m (Based on the trailing twelve months to September 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. 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?
Return on Equity measures a company's profitability against the profit it has kept for the business (plus any capital injections). The 'return' is the yearly profit. A higher profit will lead to a higher ROE. So, all else being equal, a high ROE is better than a low one. That means ROE can be used to compare two businesses.
Does Stille 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. 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, Stille has a higher ROE than the average (6.2%) in the Medical Equipment industry.
That's clearly a positive. In my book, a high ROE almost always warrants a closer look. 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. That cash can come from retained earnings, issuing new shares (equity), 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 required for growth will boost returns, but will not impact the shareholders' equity. That will make the ROE look better than if no debt was used.
Stille's Debt And Its 25% ROE
Shareholders will be pleased to learn that Stille has not one iota of net debt! Its impressive ROE suggests it is a high quality business, but it's even better to have achieved that without leverage. 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 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.
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 Stille by looking at this visualization of past earnings, revenue and cash flow.
But note: Stille 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.
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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