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 Montea Comm. VA (EBR:MONT), by way of a worked example.
Our data shows Montea Comm. VA has a return on equity of 14% for the last year. Another way to think of that is that for every €1 worth of equity in the company, it was able to earn €0.14.
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How Do You Calculate ROE?
The formula for ROE is:
Return on Equity = Net Profit ÷ Shareholders’ Equity
Or for Montea Comm. VA:
14% = 58.458 ÷ €419m (Based on the trailing twelve months to September 2018.)
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 ROE Signify?
ROE looks at the amount a company earns relative to the money it has kept within the business. The ‘return’ is the profit over the last twelve months. The higher the ROE, the more profit the company is making. So, all else being equal, a high ROE is better than a low one. That means ROE can be used to compare two businesses.
Does Montea Comm. VA 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. However, this method is only useful as a rough check, because companies do differ quite a bit within the same industry classification. Pleasingly, Montea Comm. VA has a superior ROE than the average (9.0%) company in the REITs industry.
That’s what I like to see. In my book, a high ROE almost always warrants a closer look. For example you might check if insiders are buying shares.
How Does Debt Impact Return On Equity?
Companies usually need to invest money 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.
Montea Comm. VA’s Debt And Its 14% ROE
While Montea Comm. VA does have some debt, with debt to equity of just 0.99, we wouldn’t say debt is excessive. The combination of modest debt and a very respectable ROE suggests this is a business worth watching. 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.
But It’s Just One Metric
Return on equity is a useful indicator of the ability of a business to generate profits and return them to shareholders. In my book the highest quality companies have high return on equity, despite low debt. 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.
But when a business is high quality, the market often bids it up to a price that reflects this. 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.
Of course Montea Comm. VA 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.
To help readers see past the short term volatility of the financial market, we aim to bring you a long-term focused research analysis purely driven by fundamental data. Note that our analysis does not factor in the latest price-sensitive company announcements.
The author is an independent contributor and at the time of publication had no position in the stocks mentioned. For errors that warrant correction please contact the editor at editorial-team@simplywallst.com.