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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 ORPEA Société Anonyme (EPA:ORP), by way of a worked example.
Our data shows ORPEA Société Anonyme has a return on equity of 7.4% for the last year. One way to conceptualize this, is that for each €1 of shareholders' equity it has, the company made €0.074 in profit.
See our latest analysis for ORPEA Société Anonyme
How Do I Calculate ROE?
The formula for ROE is:
Return on Equity = Net Profit ÷ Shareholders' Equity
Or for ORPEA Société Anonyme:
7.4% = €220m ÷ €3.0b (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 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 Return On Equity Mean?
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. A higher profit will lead to a higher ROE. So, all else equal, investors should like a high ROE. That means ROE can be used to compare two businesses.
Does ORPEA Société Anonyme Have A Good Return On Equity?
One simple way to determine if a company has a good return on equity is to compare it to the average for its industry. Importantly, this is far from a perfect measure, because companies differ significantly within the same industry classification. The image below shows that ORPEA Société Anonyme has an ROE that is roughly in line with the Healthcare industry average (7.4%).
That's not overly surprising. ROE doesn't tell us if the share price is low, but it can inform us to the nature of the business. For those looking for a bargain, other factors may be more important. If you like to buy stocks alongside management, then you might just love this free list of companies. (Hint: insiders have been buying them).
How Does Debt Impact ROE?
Most companies need money -- from somewhere -- to grow their profits. That cash can come from retained earnings, issuing new shares (equity), or debt. In the first two cases, the ROE will capture this use of capital to grow. In the latter case, the debt used for growth will improve returns, but won't affect the total equity. That will make the ROE look better than if no debt was used.