In This Article:
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. To keep the lesson grounded in practicality, we'll use ROE to better understand Elkem ASA (OB:ELK).
Over the last twelve months Elkem has recorded a ROE of 9.6%. Another way to think of that is that for every NOK1 worth of equity in the company, it was able to earn NOK0.10.
See our latest analysis for Elkem
How Do I Calculate Return On Equity?
The formula for ROE is:
Return on Equity = Net Profit (from continuing operations) ÷ Shareholders' Equity
Or for Elkem:
9.6% = kr1.2b ÷ kr13b (Based on the trailing twelve months to September 2019.)
Most readers would understand what net profit is, but it’s worth explaining the concept of shareholders’ equity. 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 Return On Equity Signify?
Return on Equity measures a company's profitability against the profit it has kept for the business (plus any capital injections). 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. That means it can be interesting to compare the ROE of different companies.
Does Elkem 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. Importantly, this is far from a perfect measure, because companies differ significantly within the same industry classification. You can see in the graphic below that Elkem has an ROE that is fairly close to the average for the Chemicals industry (10%).
That isn't amazing, but it is respectable. ROE can give us a view about company quality, but many investors also look to other factors, such as whether there are insiders buying shares. If you like to buy stocks alongside management, then you might just love this free list of companies. (Hint: insiders have been buying them).
The Importance Of Debt To Return On Equity
Companies usually need to invest money to grow their profits. The cash for investment can come from prior year profits (retained earnings), issuing new shares, or borrowing. In the first two cases, the ROE will capture this use of capital to grow. In the latter case, the debt required for growth will boost returns, but will not impact the shareholders' equity. Thus the use of debt can improve ROE, albeit along with extra risk in the case of stormy weather, metaphorically speaking.