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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. We'll use ROE to examine Atlas Copco AB (STO:ATCO A), by way of a worked example.
Over the last twelve months Atlas Copco has recorded a ROE of 35%. One way to conceptualize this, is that for each SEK1 of shareholders' equity it has, the company made SEK0.35 in profit.
Check out our latest analysis for Atlas Copco
How Do I Calculate Return On Equity?
The formula for ROE is:
Return on Equity = Net Profit ÷ Shareholders' Equity
Or for Atlas Copco:
35% = kr16b ÷ kr47b (Based on the trailing twelve months to March 2019.)
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 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 ROE Signify?
ROE measures a company's profitability against the profit it retains, and any outside investments. The 'return' is the yearly profit. 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 ROE can be used to compare two businesses.
Does Atlas Copco 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. 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, Atlas Copco has a better ROE than the average (21%) in the Machinery industry.
That is a good sign. 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.
Why You Should Consider Debt When Looking At ROE
Most companies need money -- from somewhere -- to grow their profits. That cash can come from retained earnings, issuing new shares (equity), 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.