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 Property For Industry Limited (NZSE:PFI).
Property For Industry has a ROE of 10%, based on the last twelve months. One way to conceptualize this, is that for each NZ$1 of shareholders’ equity it has, the company made NZ$0.10 in profit.
See our latest analysis for Property For Industry
How Do I Calculate Return On Equity?
The formula for ROE is:
Return on Equity = Net Profit ÷ Shareholders’ Equity
Or for Property For Industry:
10% = NZ$87m ÷ NZ$853m (Based on the trailing twelve months to June 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. The easiest way to calculate shareholders’ equity is to subtract the company’s total liabilities from the 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. The higher the ROE, the more profit the company is making. So, all else being equal, a high ROE is better than a low one. That means it can be interesting to compare the ROE of different companies.
Does Property For Industry 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. You can see in the graphic below that Property For Industry has an ROE that is fairly close to the average for the reits industry (10%).
That isn’t amazing, but it is respectable. ROE can change from year to year, based on decisions that have been made in the past. So savvy investors often note how long the CEO has been in that position.
How Does Debt Impact ROE?
Virtually all companies need money to invest in the business, to grow profits. The cash for investment can come from prior year profits (retained earnings), issuing new shares, or borrowing. In the first and second cases, the ROE will reflect this use of cash for investment in the business. In the latter case, the use of debt will improve the returns, but will not change the equity. In this manner the use of debt will boost ROE, even though the core economics of the business stay the same.