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Is Orica Limited's (ASX:ORI) 8.3% ROE Better Than Average?

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. By way of learning-by-doing, we'll look at ROE to gain a better understanding of Orica Limited (ASX:ORI).

Our data shows Orica has a return on equity of 8.3% 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$0.08.

See our latest analysis for Orica

How Do I Calculate Return On Equity?

The formula for return on equity is:

Return on Equity = Net Profit (from continuing operations) ÷ Shareholders' Equity

Or for Orica:

8.3% = AU$251m ÷ AU$3.0b (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 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 ROE Mean?

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 equal, investors should like a high ROE. That means ROE can be used to compare two businesses.

Does Orica 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. Importantly, this is far from a perfect measure, because companies differ significantly within the same industry classification. As you can see in the graphic below, Orica has a higher ROE than the average (5.8%) in the Chemicals industry.

ASX:ORI Past Revenue and Net Income, January 18th 2020
ASX:ORI Past Revenue and Net Income, January 18th 2020

That is a good sign. I usually take a closer look when a company has a better ROE than industry peers. One data point to check is if insiders have bought shares recently.

The Importance Of Debt To 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 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.

Orica's Debt And Its 8.3% ROE

While Orica does have some debt, with debt to equity of just 0.67, we wouldn't say debt is excessive. Its ROE isn't particularly impressive, but the debt levels are quite modest, so the business probably has some real potential. Conservative use of debt to boost returns is usually a good move for shareholders, though it does leave the company more exposed to interest rate rises.

The Key Takeaway

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. Profit growth rates, versus the expectations reflected in the price of the stock, are a particularly important to consider. So you might want to take a peek at this data-rich interactive graph of forecasts for the company.

Of course Orica 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.

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.

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. Thank you for reading.

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