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 KPS AG (FRA:KSC), by way of a worked example.

Over the last twelve months KPS has recorded a ROE of 22%. Another way to think of that is that for every €1 worth of equity in the company, it was able to earn €0.22.

Check out our latest analysis for KPS

How Do You Calculate Return On Equity?

The formula for return on equity is:

Return on Equity = Net Profit ÷ Shareholders’ Equity

Or for KPS:

22% = 13.574 ÷ €61m (Based on the trailing twelve months to June 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 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 profit over the last twelve months. That means that the higher the ROE, the more profitable the company is. So, all else equal, investors should like a high ROE. That means ROE can be used to compare two businesses.

Does KPS 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. 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, KPS has a higher ROE than the average (17%) in the it industry.

That’s clearly a positive. In my book, a high ROE almost always warrants a closer look. 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 issuing shares, retained earnings, 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.

KPS’s Debt And Its 22% ROE

Although KPS does use debt, its debt to equity ratio of 0.52 is still low. The combination of modest debt and a very impressive ROE does suggest that the business is high quality. Judicious use of debt to improve returns can certainly be a good thing, although it does elevate risk slightly and reduce future optionality.