In This Article:
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 ISS A/S (CPH:ISS), by way of a worked example.
Over the last twelve months ISS has recorded a ROE of 15%. That means that for every DKK1 worth of shareholders' equity, it generated DKK0.15 in profit.
Check out our latest analysis for ISS
How Do You Calculate Return On Equity?
The formula for return on equity is:
Return on Equity = Net Profit ÷ Shareholders' Equity
Or for ISS:
15% = ø1.7b ÷ ø11b (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 the capital paid in by shareholders, plus any retained earnings. 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 profit over the last twelve months. The higher the ROE, the more profit the company is making. So, as a general rule, a high ROE is a good thing. That means it can be interesting to compare the ROE of different companies.
Does ISS 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 you can see in the graphic below, ISS has a higher ROE than the average (10%) in the Commercial Services industry.
That's what I like to see. In my book, a high ROE almost always warrants a closer look. For example you might check if insiders are buying shares.
How Does Debt Impact Return On Equity?
Companies usually need to invest money to grow their profits. That cash can come from issuing shares, retained earnings, 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 debt used for growth will improve returns, but won't affect the total equity. In this manner the use of debt will boost ROE, even though the core economics of the business stay the same.
Combining ISS's Debt And Its 15% Return On Equity
ISS does use a significant amount of debt to increase returns. It has a debt to equity ratio of 1.86. Its ROE is quite good but, it would have probably been lower without the use of debt. Debt does bring extra risk, so it's only really worthwhile when a company generates some decent returns from it.