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 7FIT S.A. (WSE:7FT), by way of a worked example.
Over the last twelve months 7FIT has recorded a ROE of 20%. Another way to think of that is that for every PLN1 worth of equity in the company, it was able to earn PLN0.20.
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 7FIT:
20% = zł400k ÷ zł2.0m (Based on the trailing twelve months to September 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 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 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 yearly profit. That means that the higher the ROE, the more profitable the company is. So, all else equal, investors should like a high ROE. That means ROE can be used to compare two businesses.
Does 7FIT 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. The limitation of this approach is that some companies are quite different from others, even within the same industry classification. Pleasingly, 7FIT has a superior ROE than the average (11%) company in the Specialty Retail industry.
That is a good sign. I usually take a closer look when a company has a better ROE than industry peers. For example, I often check if insiders have been buying shares.
How Does Debt Impact 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. In this manner the use of debt will boost ROE, even though the core economics of the business stay the same.
7FIT’s Debt And Its 20% ROE
While 7FIT does have some debt, with debt to equity of just 0.94, we wouldn’t say debt is excessive. Its very respectable ROE, combined with only modest debt, suggests the business is in good shape. 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.
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 the same ROE, then I would generally prefer the one with less debt.
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 7FIT by looking at this visualization of past earnings, revenue and cash flow.
If you would prefer check out another company — one with potentially superior financials — then do not miss thisfree list of interesting companies, that have HIGH return on equity and low debt.
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.
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