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. To keep the lesson grounded in practicality, we'll use ROE to better understand Midsona AB (publ) (STO:MSON B).
Midsona has a ROE of 5.5%, based on the last twelve months. That means that for every SEK1 worth of shareholders' equity, it generated SEK0.06 in profit.
How Do I Calculate Return On Equity?
The formula for ROE is:
Return on Equity = Net Profit ÷ Shareholders' Equity
Or for Midsona:
5.5% = kr95m ÷ kr1.7b (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 the money paid into the company from shareholders, plus any earnings retained. You can calculate shareholders' equity by subtracting the company's total liabilities from its total assets.
What Does ROE Signify?
ROE measures a company's profitability against the profit it retains, and any outside investments. The 'return' is the amount earned after tax over the last twelve months. A higher profit will lead to a higher ROE. So, all else equal, investors should like a high ROE. That means ROE can be used to compare two businesses.
Does Midsona 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. As shown in the graphic below, Midsona has a lower ROE than the average (11%) in the Personal Products industry classification.
Unfortunately, that's sub-optimal. We'd prefer see an ROE above the industry average, but it might not matter if the company is undervalued. Nonetheless, it might be wise to check if insiders have been selling.
How Does Debt Impact Return On Equity?
Most companies need money -- from somewhere -- 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 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.
Combining Midsona's Debt And Its 5.5% Return On Equity
While Midsona does have some debt, with debt to equity of just 0.77, we wouldn't say debt is excessive. I'm not impressed with its ROE, but the debt levels are not too high, indicating the business has decent prospects. 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.
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. All else being equal, a higher ROE is better.
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 take a peek at this data-rich interactive graph of forecasts for the company.
If you would prefer check out another company -- one with potentially superior financials -- then do not miss thisfree list of interesting companies, that have HIGH return on equity 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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