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 BioNeutra Global Corporation (CVE:BGA).
Over the last twelve months BioNeutra Global has recorded a ROE of 2.1%. That means that for every CA$1 worth of shareholders’ equity, it generated CA$0.021 in profit.
How Do I Calculate Return On Equity?
The formula for ROE is:
Return on Equity = Net Profit ÷ Shareholders’ Equity
Or for BioNeutra Global:
2.1% = CA$347k ÷ CA$17m (Based on the trailing twelve months to March 2019.)
Most readers would understand what net profit is, but it’s worth explaining the concept of shareholders’ equity. It is all earnings retained by the company, plus any capital paid in by shareholders. You can calculate shareholders’ equity by subtracting the company’s total liabilities from its total assets.
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. A higher profit will lead to a higher ROE. So, all else being equal, a high ROE is better than a low one. Clearly, then, one can use ROE to compare different companies.
Does BioNeutra Global Have A Good Return On Equity?
By comparing a company’s ROE with its industry average, we can get a quick measure of how good it is. The limitation of this approach is that some companies are quite different from others, even within the same industry classification. As is clear from the image below, BioNeutra Global has a lower ROE than the average (15%) in the Personal Products industry.
Unfortunately, that’s sub-optimal. It is better when the ROE is above industry average, but a low one doesn’t necessarily mean the business is overpriced. Nonetheless, it could be useful to double-check if insiders have sold shares recently.
Why You Should Consider Debt When Looking At ROE
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 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. In this manner the use of debt will boost ROE, even though the core economics of the business stay the same.
Combining BioNeutra Global’s Debt And Its 2.1% Return On Equity
Although BioNeutra Global does use debt, its debt to equity ratio of 0.52 is still low. Its ROE is quite low, and the company already has some debt, so surely shareholders are hoping for an improvement. Careful use of debt to boost returns is often very good for shareholders. However, it could reduce the company’s ability to take advantage of future opportunities.
Return on equity is useful for comparing the quality of different businesses. In my book the highest quality companies have high return on equity, despite low debt. 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. Profit growth rates, versus the expectations reflected in the price of the stock, are a particularly important to consider. You can see how the company has grow in the past by looking at this FREE detailed graph of past earnings, revenue and cash flow.
Of course, you might find a fantastic investment by looking elsewhere. So take a peek at this free list of interesting companies.
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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.