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 F.I.L.A. - Fabbrica Italiana Lapis ed Affini S.p.A. (BIT:FILA).
Over the last twelve months F.I.L.A. - Fabbrica Italiana Lapis ed Affini has recorded a ROE of 6.6%. One way to conceptualize this, is that for each €1 of shareholders' equity it has, the company made €0.066 in profit.
How Do You Calculate ROE?
The formula for ROE is:
Return on Equity = Net Profit ÷ Shareholders' Equity
Or for F.I.L.A. - Fabbrica Italiana Lapis ed Affini:
6.6% = €20m ÷ €343m (Based on the trailing twelve months to June 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 the money paid into the company from shareholders, plus any earnings retained. The easiest way to calculate shareholders' equity is to subtract the company's total liabilities from the total assets.
What Does Return On Equity Mean?
ROE measures a company's profitability against the profit it retains, and any outside investments. The 'return' is the profit 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 F.I.L.A. - Fabbrica Italiana Lapis ed Affini 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. Importantly, this is far from a perfect measure, because companies differ significantly within the same industry classification. If you look at the image below, you can see F.I.L.A. - Fabbrica Italiana Lapis ed Affini has a lower ROE than the average (11%) in the Commercial Services industry classification.
That's not what we like to see. 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.
The Importance Of Debt To Return On Equity
Virtually all companies need money to invest in the business, to grow profits. The cash for investment can come from prior year profits (retained earnings), issuing new shares, or borrowing. 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. Thus the use of debt can improve ROE, albeit along with extra risk in the case of stormy weather, metaphorically speaking.
Combining F.I.L.A. - Fabbrica Italiana Lapis ed Affini's Debt And Its 6.6% Return On Equity
F.I.L.A. - Fabbrica Italiana Lapis ed Affini clearly uses a significant amount of debt to boost returns, as it has a debt to equity ratio of 1.63. 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 does bring extra risk, so it's only really worthwhile when a company generates some decent returns from it.
The Bottom Line On ROE
Return on equity is one way we can compare the business quality of different companies. 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. Profit growth rates, versus the expectations reflected in the price of the stock, are a particularly important to consider. So I think it may be worth checking this free report on analyst forecasts for the company.
But note: F.I.L.A. - Fabbrica Italiana Lapis ed Affini 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.
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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. Thank you for reading.