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. We’ll use ROE to examine F.I.L.A. – Fabbrica Italiana Lapis ed Affini S.p.A. (BIT:FILA), by way of a worked example.
Our data shows F.I.L.A. – Fabbrica Italiana Lapis ed Affini has a return on equity of 6.6% for the last year. That means that for every €1 worth of shareholders’ equity, it generated €0.07 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 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. 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 yearly profit. A higher profit will lead to a higher ROE. So, all else equal, investors should like a high ROE. That means ROE can be used to compare two businesses.
Does F.I.L.A. – Fabbrica Italiana Lapis ed Affini 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. However, this method is only useful as a rough check, because companies do differ quite a bit within the same industry classification. As is clear from the image below, F.I.L.A. – Fabbrica Italiana Lapis ed Affini has a lower ROE than the average (11%) in the Commercial Services industry.
That’s not what we like to see. It is better when the ROE is above industry average, but a low one doesn’t necessarily mean the business is overpriced. Still, shareholders might want to check if insiders have been selling.
The Importance Of Debt To Return On Equity
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. That will make the ROE look better than if no debt was used.
F.I.L.A. – Fabbrica Italiana Lapis ed Affini’s Debt And Its 6.6% ROE
It’s worth noting the significant use of debt by F.I.L.A. – Fabbrica Italiana Lapis ed Affini, leading to its debt to equity ratio of 1.63. Its ROE isn’t too bad, but it would probably be very disappointing if the company had to stop using debt. Debt increases risk and reduces options for the company in the future, so you generally want to see some good returns from using it.
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. All else being equal, a higher ROE is better.
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. 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. So you might want to take a peek at this data-rich interactive graph of 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.
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 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.