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). To keep the lesson grounded in practicality, we'll use ROE to better understand Washington H. Soul Pattinson and Company Limited (ASX:SOL).

Our data shows Washington H. Soul Pattinson has a return on equity of 8.0% for the last year. That means that for every A$1 worth of shareholders' equity, it generated A$0.08 in profit.

See our latest analysis for Washington H. Soul Pattinson

How Do You Calculate ROE?

The formula for ROE is:

Return on Equity = Net Profit (from continuing operations) ÷ Shareholders' Equity

Or for Washington H. Soul Pattinson:

8.0% = AU$359m ÷ AU$4.5b (Based on the trailing twelve months to July 2019.)

Most readers would understand what net profit is, but it’s worth explaining the concept of shareholders’ equity. It is the capital paid in by shareholders, plus any retained earnings. The easiest way to calculate shareholders' equity is to subtract the company's total liabilities from the total assets.

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 yearly profit. The higher the ROE, the more profit the company is making. So, as a general rule, a high ROE is a good thing. Clearly, then, one can use ROE to compare different companies.

Does Washington H. Soul Pattinson Have A Good Return On Equity?

Arguably the easiest way to assess company's ROE is to compare it with the average in its industry. The limitation of this approach is that some companies are quite different from others, even within the same industry classification. If you look at the image below, you can see Washington H. Soul Pattinson has a lower ROE than the average (12%) in the Oil and Gas industry classification.

That's not what we like to see. 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. Nonetheless, it could be useful to double-check if insiders have sold shares recently.

How Does Debt Impact ROE?

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 two cases, the ROE will capture this use of capital to grow. 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.