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 Samko Timber Limited (SGX:E6R), by way of a worked example.
Return on Equity or ROE is a test of how effectively a company is growing its value and managing investors’ money. In short, ROE shows the profit each dollar generates with respect to its shareholder investments.
View our latest analysis for Samko Timber
How Is ROE Calculated?
ROE can be calculated by using the formula:
Return on Equity = Net Profit (from continuing operations) ÷ Shareholders' Equity
So, based on the above formula, the ROE for Samko Timber is:
4.9% = Rp17b ÷ Rp352b (Based on the trailing twelve months to June 2022).
The 'return' is the profit over the last twelve months. So, this means that for every SGD1 of its shareholder's investments, the company generates a profit of SGD0.05.
Does Samko Timber Have A Good Return On Equity?
One simple way to determine if a company has a good return on equity is to compare it to the average for its industry. Importantly, this is far from a perfect measure, because companies differ significantly within the same industry classification. As is clear from the image below, Samko Timber has a lower ROE than the average (6.6%) in the Forestry industry.
Unfortunately, that's sub-optimal. Although, we think that a lower ROE could still mean that a company has the opportunity to better its returns with the use of leverage, provided its existing debt levels are low. When a company has low ROE but high debt levels, we would be cautious as the risk involved is too high. To know the 4 risks we have identified for Samko Timber visit our risks dashboard for free.
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 case of the first and second options, the ROE will reflect this use of cash, for growth. 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.
Combining Samko Timber's Debt And Its 4.9% Return On Equity
It appears that Samko Timber makes extensive use of debt to improve its returns, because it has an alarmingly high debt to equity ratio of 5.40. We consider it to be a negative sign when a company has a rather low ROE despite a rather high debt to equity.