Many investors are still learning about the various metrics that can be useful when analysing a stock. This article is for those who would like to learn about Return On Equity (ROE). We'll use ROE to examine Financiere et Immobiliere de l'Etang de Berre et de la Mediterranee S.A. (EPA:BERR), by way of a worked example.
Over the last twelve months Financiere et Immobiliere de l'Etang de Berre et de la Mediterranee has recorded a ROE of 3.6%. One way to conceptualize this, is that for each €1 of shareholders' equity it has, the company made €0.036 in profit.
See our latest analysis for Financiere et Immobiliere de l'Etang de Berre et de la Mediterranee
How Do I Calculate ROE?
The formula for return on equity is:
Return on Equity = Net Profit ÷ Shareholders' Equity
Or for Financiere et Immobiliere de l'Etang de Berre et de la Mediterranee:
3.6% = €194k ÷ €5.3m (Based on the trailing twelve months to December 2018.)
Most readers would understand what net profit is, but it’s worth explaining the concept of shareholders’ equity. It is all the money paid into the company from shareholders, plus any earnings retained. Shareholders' equity can be calculated by subtracting the total liabilities of the company from the total assets of the company.
What Does ROE Mean?
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, all else being equal, a high ROE is better than a low one. That means ROE can be used to compare two businesses.
Does Financiere et Immobiliere de l'Etang de Berre et de la Mediterranee Have A Good ROE?
Arguably the easiest way to assess company's ROE is to compare it with the average in its industry. However, this method is only useful as a rough check, because companies do differ quite a bit within the same industry classification. As is clear from the image below, Financiere et Immobiliere de l'Etang de Berre et de la Mediterranee has a lower ROE than the average (9.8%) in the Real Estate industry.
That certainly isn't ideal. We prefer it when the ROE of a company is above the industry average, but it's not the be-all and end-all if it is lower. Still, shareholders might want to check if insiders have been selling.
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 debt required for growth will boost returns, but will not impact the shareholders' equity. In this manner the use of debt will boost ROE, even though the core economics of the business stay the same.