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Many investors are still learning about the various metrics that can be useful when analysing a stock. This article is for those who would like to learn about Return On Equity (ROE). To keep the lesson grounded in practicality, we'll use ROE to better understand Magontec Limited (ASX:MGL).
Over the last twelve months Magontec has recorded a ROE of 2.5%. That means that for every A$1 worth of shareholders' equity, it generated A$0.025 in profit.
View our latest analysis for Magontec
How Do You Calculate Return On Equity?
The formula for ROE is:
Return on Equity = Net Profit ÷ Shareholders' Equity
Or for Magontec:
2.5% = AU$850k ÷ AU$34m (Based on the trailing twelve months to June 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. 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 amount earned after tax over the last twelve months. 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 Magontec Have A Good ROE?
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. If you look at the image below, you can see Magontec has a lower ROE than the average (14%) in the Metals and Mining industry classification.
That certainly isn't ideal. We'd prefer see an ROE above the industry average, but it might not matter if the company is undervalued. Nonetheless, it might be wise to check if insiders have been selling.
How Does Debt Impact ROE?
Most companies need money -- from somewhere -- 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 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.
Combining Magontec's Debt And Its 2.5% Return On Equity
While Magontec does have some debt, with debt to equity of just 0.59, we wouldn't say debt is excessive. Its ROE is certainly on the low side, and since it already uses debt, we're not too excited about the company. Judicious use of debt to improve returns can certainly be a good thing, although it does elevate risk slightly and reduce future optionality.