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. To keep the lesson grounded in practicality, we’ll use ROE to better understand STEF SA (EPA:STF).
ROE or return on equity is a useful tool to assess how effectively a company can generate returns on the investment it received from its shareholders. Put another way, it reveals the company’s success at turning shareholder investments into profits.
How To Calculate Return On Equity?
The formula for ROE is:
Return on Equity = Net Profit (from continuing operations) ÷ Shareholders’ Equity
So, based on the above formula, the ROE for STEF is:
9.7% = €75m ÷ €776m (Based on the trailing twelve months to June 2020).
The ‘return’ is the yearly profit. One way to conceptualize this is that for each €1 of shareholders’ capital it has, the company made €0.10 in profit.
Does STEF Have A Good ROE?
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. You can see in the graphic below that STEF has an ROE that is fairly close to the average for the Transportation industry (9.4%).
So while the ROE is not exceptional, at least its acceptable. Although the ROE is similar to the industry, we should still perform further checks to see if the company’s ROE is being boosted by high debt levels. If true, then it is more an indication of risk than the potential.
How Does Debt Impact ROE?
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 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.
Combining STEF’s Debt And Its 9.7% Return On Equity
STEF clearly uses a high amount of debt to boost returns, as it has a debt to equity ratio of 1.01. The combination of a rather low ROE and significant use of debt is not particularly appealing. Debt does bring extra risk, so it’s only really worthwhile when a company generates some decent returns from 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. If two companies have the same ROE, then I would generally prefer the one with less debt.
But ROE is just one piece of a bigger puzzle, since high quality businesses often trade on high multiples of earnings. It is important to consider other factors, such as future profit growth — and how much investment is required going forward. So you might want to check this FREE visualization of analyst forecasts for the company.
If you would prefer check out another company — one with potentially superior financials — then do not miss this free list of interesting companies, that have HIGH return on equity and low debt.
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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. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any stocks mentioned.
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