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 Papoutsanis S.A. (ATH:PAP).
Over the last twelve months Papoutsanis has recorded a ROE of 8.3%. That means that for every €1 worth of shareholders' equity, it generated €0.08 in profit.
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 Papoutsanis:
8.3% = €1.6m ÷ €19m (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 the capital paid in by shareholders, plus any retained earnings. Shareholders' equity can be calculated by subtracting the total liabilities of the company from the total assets of the company.
What Does Return On Equity 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. That means that the higher the ROE, the more profitable the company is. So, as a general rule, a high ROE is a good thing. Clearly, then, one can use ROE to compare different companies.
Does Papoutsanis Have A Good Return On Equity?
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 Papoutsanis has a lower ROE than the average (11%) in the Personal Products industry classification.
That certainly isn't ideal. We prefer it when the ROE of a company is above the industry average, but it's not the be-all and end-all if it is lower. Nonetheless, it could be useful to double-check if insiders have sold shares recently.
Why You Should Consider Debt When Looking At ROE
Most companies need money -- from somewhere -- to grow their profits. The cash for investment can come from prior year profits (retained earnings), issuing new shares, or borrowing. In the first and second cases, the ROE will reflect this use of cash for investment in the business. 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 Papoutsanis's Debt And Its 8.3% Return On Equity
Papoutsanis has a debt to equity ratio of 0.41, which is far from excessive. I'm not impressed with its ROE, but the debt levels are not too high, indicating the business has decent prospects. 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 a useful indicator of the ability of a business to generate profits and return them to shareholders. A company that can achieve a high return on equity without debt could be considered a high quality business. 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. 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.
Of course Papoutsanis 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 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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