While some investors are already well versed in financial metrics (hat tip), this article is for those who would like to learn about Return On Equity (ROE) and why it is important. We'll use ROE to examine Svejsemaskinefabrikken Migatronic A/S (CPH:MIGA B), by way of a worked example.
Our data shows Svejsemaskinefabrikken Migatronic has a return on equity of 6.9% for the last year. Another way to think of that is that for every DKK1 worth of equity in the company, it was able to earn DKK0.069.
How Do I Calculate ROE?
The formula for ROE is:
Return on Equity = Net Profit ÷ Shareholders' Equity
Or for Svejsemaskinefabrikken Migatronic:
6.9% = ø9.6m ÷ ø138m (Based on the trailing twelve months to December 2018.)
Most readers would understand what net profit is, but it’s worth explaining the concept of shareholders’ equity. It is the capital paid in by shareholders, plus any retained earnings. 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. 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 Svejsemaskinefabrikken Migatronic Have A Good ROE?
By comparing a company's ROE with its industry average, we can get a quick measure of how good it is. The limitation of this approach is that some companies are quite different from others, even within the same industry classification. You can see in the graphic below that Svejsemaskinefabrikken Migatronic has an ROE that is fairly close to the average for the Machinery industry (6.9%).
That's not overly surprising. ROE doesn't tell us if the share price is low, but it can inform us to the nature of the business. For those looking for a bargain, other factors may be more important. I will like Svejsemaskinefabrikken Migatronic better if I see some big insider buys. While we wait, check out this free list of growing companies with considerable, recent, insider buying.
The Importance Of Debt To Return On Equity
Most companies need money -- from somewhere -- to grow their profits. That cash can come from issuing shares, retained earnings, 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 debt used for growth will improve returns, but won't affect the total equity. That will make the ROE look better than if no debt was used.
Svejsemaskinefabrikken Migatronic's Debt And Its 6.9% ROE
Svejsemaskinefabrikken Migatronic has a debt to equity ratio of just 0.091, which is very low. Its ROE isn't particularly impressive, but the debt levels are quite modest, so the business probably has some real potential. 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.
Return on equity is useful for comparing the quality of different businesses. 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 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. Check the past profit growth by Svejsemaskinefabrikken Migatronic by looking at this visualization of past earnings, revenue and cash flow.
Of course Svejsemaskinefabrikken Migatronic 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.
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.
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.