In This Article:
While some investors are already well versed in financial metrics (hat tip), this article is for those who would like to learn about Return On Equity (ROE) and why it is important. By way of learning-by-doing, we'll look at ROE to gain a better understanding of Fabasoft AG (ETR:FAA).
Fabasoft has a ROE of 25%, based on the last twelve months. Another way to think of that is that for every €1 worth of equity in the company, it was able to earn €0.25.
Check out our latest analysis for Fabasoft
How Do You Calculate ROE?
The formula for return on equity is:
Return on Equity = Net Profit (from continuing operations) ÷ Shareholders' Equity
Or for Fabasoft:
25% = €7.1m ÷ €28m (Based on the trailing twelve months to December 2019.)
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 ROE Mean?
ROE looks at the amount a company earns relative to the money it has kept within the business. The 'return' is the yearly profit. That means that the higher the ROE, the more profitable the company is. So, all else equal, investors should like a high ROE. Clearly, then, one can use ROE to compare different companies.
Does Fabasoft 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, Fabasoft has a better ROE than the average (11%) in the Software industry.
That's clearly a positive. We think a high ROE, alone, is usually enough to justify further research into a company. For example you might check if insiders are buying shares.
Why You Should Consider Debt When Looking At ROE
Companies usually need to invest money 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 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.
Combining Fabasoft's Debt And Its 25% Return On Equity
Fabasoft 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. At the end of the day, when a company has zero debt, it is in a better position to take future growth opportunities.