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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 DO & CO Aktiengesellschaft (VIE:DOC), by way of a worked example.
Our data shows DO & CO has a return on equity of 15% for the last year. That means that for every €1 worth of shareholders' equity, it generated €0.15 in profit.
See our latest analysis for DO & CO
How Do You Calculate Return On Equity?
The formula for return on equity is:
Return on Equity = Net Profit (from continuing operations) ÷ Shareholders' Equity
Or for DO & CO:
15% = €40m ÷ €268m (Based on the trailing twelve months to September 2019.)
It's easy to understand the 'net profit' part of that equation, but 'shareholders' equity' requires further explanation. It is all earnings retained by the company, plus any capital paid in by shareholders. The easiest way to calculate shareholders' equity is to subtract the company's total liabilities from the total assets.
What Does Return On Equity Signify?
ROE looks at the amount a company earns relative to the money it has kept within the business. The 'return' is the yearly profit. A higher profit will lead to a higher ROE. So, all else equal, investors should like a high ROE. Clearly, then, one can use ROE to compare different companies.
Does DO & CO 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. However, this method is only useful as a rough check, because companies do differ quite a bit within the same industry classification. As you can see in the graphic below, DO & CO has a higher ROE than the average (8.4%) in the Hospitality industry.
That is a good sign. I usually take a closer look when a company has a better ROE than industry peers. For example, I often check if insiders have been buying shares.
Why You Should Consider Debt When Looking At ROE
Virtually all companies need money to invest in the business, to grow 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 required for growth will boost returns, but will not impact the shareholders' equity. That will make the ROE look better than if no debt was used.
DO & CO's Debt And Its 15% ROE
DO & CO clearly uses a significant amount of debt to boost returns, as it has a debt to equity ratio of 1.09. while its ROE is respectable, it is worth keeping in mind that there is usually a limit to how much debt a company can use. Debt does bring extra risk, so it's only really worthwhile when a company generates some decent returns from it.