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 Aware, Inc. (NASDAQ:AWRE), by way of a worked example.
Aware has a ROE of 2.0%, based on the last twelve months. Another way to think of that is that for every $1 worth of equity in the company, it was able to earn $0.02.
How Do I Calculate Return On Equity?
The formula for ROE is:
Return on Equity = Net Profit ÷ Shareholders’ Equity
Or for Aware:
2.0% = US$1.2m ÷ US$61m (Based on the trailing twelve months to June 2019.)
It’s easy to understand the ‘net profit’ part of that equation, but ‘shareholders’ equity’ requires further explanation. It is all earnings retained by the company, plus any capital paid in by shareholders. You can calculate shareholders’ equity by subtracting the company’s total liabilities from its 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 profit over the last twelve months. A higher profit will lead to a higher ROE. So, all else being equal, a high ROE is better than a low one. Clearly, then, one can use ROE to compare different companies.
Does Aware 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. As is clear from the image below, Aware has a lower ROE than the average (9.1%) in the Software industry.
Unfortunately, that’s sub-optimal. 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. Still, shareholders might want to check if insiders have been selling.
Why You Should Consider Debt When Looking At ROE
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 debt required for growth will boost returns, but will not impact the shareholders’ equity. In this manner the use of debt will boost ROE, even though the core economics of the business stay the same.
Combining Aware’s Debt And Its 2.0% Return On Equity
Shareholders will be pleased to learn that Aware has not one iota of net debt! It’s hard to argue its ROE is much good, but the fact that no debt was used is some comfort. After all, when a company has a strong balance sheet, it can often find ways to invest in growth, even if it takes some time.
Return on equity is a useful indicator of the ability of a business to generate profits and return them to shareholders. Companies that can achieve high returns on equity without too much debt are generally of good quality. 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.
Having said that, while ROE is a useful indicator of business quality, you’ll have to look at a whole range of factors to determine the right price to buy a stock. It is important to consider other factors, such as future profit growth — and how much investment is required going forward. Check the past profit growth by Aware by looking at this visualization of past earnings, revenue and cash flow.
Of course Aware 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.
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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.