While some investors are already well versed in financial metrics (hat tip), this article is for those who would like to learn about Return On Equity (ROE) and why it is important. We’ll use ROE to examine Laurent-Perrier SA (EPA:LPE), by way of a worked example.

Over the last twelve months Laurent-Perrier has recorded a ROE of 5.1%. One way to conceptualize this, is that for each €1 of shareholders’ equity it has, the company made €0.051 in profit.

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How Do You Calculate ROE?

The formula for ROE is:

Return on Equity = Net Profit ÷ Shareholders’ Equity

Or for Laurent-Perrier:

5.1% = €21m ÷ €409m (Based on the trailing twelve months to March 2018.)

Most readers would understand what net profit is, but it’s worth explaining the concept of shareholders’ equity. 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 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 yearly profit. 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 Laurent-Perrier 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. However, this method is only useful as a rough check, because companies do differ quite a bit within the same industry classification. You can see in the graphic below that Laurent-Perrier has an ROE that is fairly close to the average for the beverage industry (5.1%).

That’s neither particularly good, nor bad. ROE can change from year to year, based on decisions that have been made in the past. So I like to check the tenure of the board and CEO, before reaching any conclusions.

How Does Debt Impact Return On Equity?

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 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.

Laurent-Perrier’s Debt And Its 5.1% ROE

While Laurent-Perrier does have some debt, with debt to equity of just 0.81, we wouldn’t say debt is excessive. Although the ROE isn’t overly impressive, the debt load is modest, suggesting the business has potential. Careful use of debt to boost returns is often very good for shareholders. However, it could reduce the company’s ability to take advantage of future opportunities.