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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. By way of learning-by-doing, we'll look at ROE to gain a better understanding of Monadelphous Group Limited (ASX:MND).
Over the last twelve months Monadelphous Group has recorded a ROE of 17%. One way to conceptualize this, is that for each A$1 of shareholders' equity it has, the company made A$0.17 in profit.
View our latest analysis for Monadelphous Group
How Do I Calculate Return On Equity?
The formula for ROE is:
Return on Equity = Net Profit ÷ Shareholders' Equity
Or for Monadelphous Group:
17% = AU$65m ÷ AU$395m (Based on the trailing twelve months to December 2018.)
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 all earnings retained by the company, plus any capital paid in by shareholders. Shareholders' equity can be calculated by subtracting the total liabilities of the company from the total assets of the company.
What Does Return On Equity 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. The higher the ROE, the more profit the company is making. So, all else being equal, a high ROE is better than a low one. That means ROE can be used to compare two businesses.
Does Monadelphous Group 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. Importantly, this is far from a perfect measure, because companies differ significantly within the same industry classification. If you look at the image below, you can see Monadelphous Group has a similar ROE to the average in the Construction industry classification (16%).
That isn't amazing, but it is respectable. ROE tells us about the quality of the business, but it does not give us much of an idea if the share price is cheap. I will like Monadelphous Group better if I see some big insider buys. While we wait, check out this free list of growing companies with considerable, recent, insider buying.
How Does Debt Impact Return On Equity?
Virtually all companies need money to invest in the business, to grow profits. That cash can come from issuing shares, retained earnings, 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. Thus the use of debt can improve ROE, albeit along with extra risk in the case of stormy weather, metaphorically speaking.