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 Ship Finance International Limited (NYSE:SFL), by way of a worked example.
Over the last twelve months Ship Finance International has recorded a ROE of 7.3%. One way to conceptualize this, is that for each $1 of shareholders’ equity it has, the company made $0.073 in profit.
How Do I Calculate ROE?
The formula for return on equity is:
Return on Equity = Net Profit ÷ Shareholders’ Equity
Or for Ship Finance International:
7.3% = 90.237 ÷ US$1.2b (Based on the trailing twelve months to September 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. You can calculate shareholders’ equity by subtracting the company’s total liabilities from its total assets.
What Does ROE 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 amount earned after tax over the last twelve months. That means that the higher the ROE, the more profitable the company is. So, as a general rule, a high ROE is a good thing. That means it can be interesting to compare the ROE of different companies.
Does Ship Finance International 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. If you look at the image below, you can see Ship Finance International has a similar ROE to the average in the shipping industry classification (8.8%).
That’s neither particularly good, nor bad. Generally it will take a while for decisions made by leadership to impact the ROE. So I like to check the tenure of the board and CEO, before reaching any conclusions.
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 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. In this manner the use of debt will boost ROE, even though the core economics of the business stay the same.
Ship Finance International’s Debt And Its 7.3% ROE
Ship Finance International does use a significant amount of debt to increase returns. It has a debt to equity ratio of 1.59. Its ROE isn’t too bad, but it would probably be very disappointing if the company had to stop using debt. Investors should think carefully about how a company might perform if it was unable to borrow so easily, because credit markets do change over time.
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. 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. Profit growth rates, versus the expectations reflected in the price of the stock, are a particularly important to consider. So you might want to check this FREE visualization of analyst forecasts for the company.
But note: Ship Finance International may not be the best stock to buy. So take a peek at this free list of interesting companies with 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 email@example.com.