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). By way of learning-by-doing, we’ll look at ROE to gain a better understanding Dynamic Colours Limited (SGX:D6U).
Our data shows Dynamic Colours has a return on equity of 8.2% for the last year. One way to conceptualize this, is that for each SGD1 of shareholders’ equity it has, the company made SGD0.082 in profit.
See our latest analysis for Dynamic Colours
How Do You Calculate Return On Equity?
The formula for ROE is:
Return on Equity = Net Profit ÷ Shareholders’ Equity
Or for Dynamic Colours:
8.2% = US$3m ÷ US$32m (Based on the trailing twelve months to June 2018.)
Most readers would understand what net profit is, but it’s worth explaining the concept of shareholders’ equity. 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 Mean?
ROE looks at the amount a company earns relative to the money it has kept within the business. The ‘return’ is the amount earned after tax over the last twelve months. A higher profit will lead to a 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 Dynamic Colours Have A Good ROE?
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. If you look at the image below, you can see Dynamic Colours has a similar ROE to the average in the chemicals industry classification (8.2%).
That’s neither particularly good, nor bad. ROE can change from year to year, based on decisions that have been made in the past. So savvy investors often note how long the CEO has been in that position.
The Importance Of Debt To Return On Equity
Virtually all companies need money to invest in the business, to grow 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. Thus the use of debt can improve ROE, albeit along with extra risk in the case of stormy weather, metaphorically speaking.