In This Article:
Want to participate in a short research study? Help shape the future of investing tools and you could win a $250 gift card!
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 RIWI Corp. (FRA:5RW), by way of a worked example.
Our data shows RIWI has a return on equity of 27% for the last year. That means that for every €1 worth of shareholders' equity, it generated €0.27 in profit.
View our latest analysis for RIWI
How Do I Calculate ROE?
The formula for return on equity is:
Return on Equity = Net Profit ÷ Shareholders' Equity
Or for RIWI:
27% = US$734k ÷ US$2.7m (Based on the trailing twelve months to March 2019.)
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 the money paid into the company from shareholders, plus any earnings retained. You can calculate shareholders' equity by subtracting the company's total liabilities from its total assets.
What Does ROE 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. That means that the higher the ROE, the more profitable the company is. So, as a general rule, a high ROE is a good thing. Clearly, then, one can use ROE to compare different companies.
Does RIWI Have A Good Return On Equity?
Arguably the easiest way to assess company's ROE is to compare it with the average in its industry. The limitation of this approach is that some companies are quite different from others, even within the same industry classification. You can see in the graphic below that RIWI has an ROE that is fairly close to the average for the Interactive Media and Services industry (27%).
That's neither particularly good, nor bad. 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. I will like RIWI better if I see some big insider buys. While we wait, check out this free list of growing companies with considerable, recent, insider buying.
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 and second cases, the ROE will reflect this use of cash for investment in the business. In the latter case, the debt required for growth will boost returns, but will not impact the shareholders' equity. In this manner the use of debt will boost ROE, even though the core economics of the business stay the same.