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 SW Umwelttechnik Stoiser & Wolschner AG (VIE:SWUT).
SW Umwelttechnik Stoiser & Wolschner has a ROE of 55%, based on the last twelve months. One way to conceptualize this, is that for each €1 of shareholders’ equity it has, the company made €0.55 in profit.
How Do I Calculate Return On Equity?
The formula for ROE is:
Return on Equity = Net Profit ÷ Shareholders’ Equity
Or for SW Umwelttechnik Stoiser & Wolschner:
55% = €4.6m ÷ €8.2m (Based on the trailing twelve months to December 2018.)
It’s easy to understand the ‘net profit’ part of that equation, but ‘shareholders’ equity’ requires further explanation. 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 looks at the amount a company earns relative to the money it has kept within the business. 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 it can be interesting to compare the ROE of different companies.
Does SW Umwelttechnik Stoiser & Wolschner 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. As you can see in the graphic below, SW Umwelttechnik Stoiser & Wolschner has a higher ROE than the average (12%) in the Construction industry.
That’s what I like to see. We think a high ROE, alone, is usually enough to justify further research into a company. For example you might check if insiders are buying shares.
The Importance Of Debt To Return On Equity
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 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. Thus the use of debt can improve ROE, albeit along with extra risk in the case of stormy weather, metaphorically speaking.
Combining SW Umwelttechnik Stoiser & Wolschner’s Debt And Its 55% Return On Equity
We think SW Umwelttechnik Stoiser & Wolschner uses a lot of debt to boost returns, as it has a relatively high debt to equity ratio of 6.58. Its ROE is no doubt quite impressive, but it would probably be a lot lower without the use of significant leverage.
The Bottom Line On ROE
Return on equity is one way we can compare the business quality of different companies. 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.
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 I think it may be worth checking this free this detailed graph of past earnings, revenue and cash flow .
Of course SW Umwelttechnik Stoiser & Wolschner 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.