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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 Straco Corporation Limited (SGX:S85), by way of a worked example.
Over the last twelve months Straco has recorded a ROE of 16%. Another way to think of that is that for every SGD1 worth of equity in the company, it was able to earn SGD0.16.
Check out our latest analysis for Straco
How Do I Calculate ROE?
The formula for return on equity is:
Return on Equity = Net Profit ÷ Shareholders' Equity
Or for Straco:
16% = S$47m ÷ S$307m (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 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 Return On Equity Mean?
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. A higher profit will lead to a higher ROE. So, as a general rule, a high ROE is a good thing. Clearly, then, one can use ROE to compare different companies.
Does Straco 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. However, this method is only useful as a rough check, because companies do differ quite a bit within the same industry classification. Pleasingly, Straco has a superior ROE than the average (8.7%) company in the Hospitality industry.
That's clearly a positive. In my book, a high ROE almost always warrants a closer look. For example, I often check if insiders have been buying shares .
How Does Debt Impact Return On Equity?
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.