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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 Data#3 Limited (ASX:DTL), by way of a worked example.
Our data shows Data#3 has a return on equity of 38% for the last year. One way to conceptualize this, is that for each A$1 of shareholders' equity it has, the company made A$0.38 in profit.
Check out our latest analysis for Data#3
How Do You Calculate Return On Equity?
The formula for ROE is:
Return on Equity = Net Profit ÷ Shareholders' Equity
Or for Data#3:
38% = AU$18m ÷ AU$47m (Based on the trailing twelve months to June 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 ROE Signify?
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 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 Data#3 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. 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, Data#3 has a better ROE than the average (15%) in the IT industry.
That is a good sign. In my book, a high ROE almost always warrants a closer look. For example, I often check if insiders have been buying shares.
Why You Should Consider Debt When Looking At 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 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.
Data#3's Debt And Its 38% ROE
Data#3 is free of net debt, which is a positive for shareholders. Its high ROE already points to a high quality business, but the lack of debt is a cherry on top. After all, with cash on the balance sheet, a company has a lot more optionality in good times and bad.