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 Magnolia Bostad AB (publ) (STO:MAG), by way of a worked example.
Magnolia Bostad has a ROE of 6.1%, based on the last twelve months. One way to conceptualize this, is that for each SEK1 of shareholders' equity it has, the company made SEK0.06 in profit.
How Do You Calculate Return On Equity?
The formula for return on equity is:
Return on Equity = Net Profit ÷ Shareholders' Equity
Or for Magnolia Bostad:
6.1% = kr58m ÷ kr1.2b (Based on the trailing twelve months to September 2019.)
It's easy to understand the 'net profit' part of that equation, but 'shareholders' equity' requires further explanation. It is all earnings retained by the company, plus any capital paid in by shareholders. You can calculate shareholders' equity by subtracting the company's total liabilities from its 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 amount earned after tax over the last twelve months. The higher the ROE, the more profit the company is making. 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 Magnolia Bostad Have A Good ROE?
One simple way to determine if a company has a good return on equity is to compare it to the average for its industry. 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 Magnolia Bostad has a lower ROE than the average (13%) in the Real Estate industry classification.
That certainly isn't ideal. It is better when the ROE is above industry average, but a low one doesn't necessarily mean the business is overpriced. Still, shareholders might want to check if insiders have been selling.
The Importance Of Debt To Return On Equity
Companies usually need to invest money 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. In this manner the use of debt will boost ROE, even though the core economics of the business stay the same.
Magnolia Bostad's Debt And Its 6.1% ROE
It's worth noting the significant use of debt by Magnolia Bostad, leading to its debt to equity ratio of 1.94. The company doesn't have a bad ROE, but it is less than ideal tht it has had to use debt to achieve its returns. Debt increases risk and reduces options for the company in the future, so you generally want to see some good returns from using it.
The Key Takeaway
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 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. 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 I think it may be worth checking this free report on analyst forecasts for the company.
Of course Magnolia Bostad may not be the best stock to buy. So you may wish to see this free collection of other companies that have high ROE and low debt.
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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.