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). We’ll use ROE to examine Scales Corporation Limited (NZSE:SCL), by way of a worked example.

Our data shows Scales has a return on equity of 15% for the last year. One way to conceptualize this, is that for each NZ$1 of shareholders’ equity it has, the company made NZ$0.15 in profit.

Check out our latest analysis for Scales

How Do I Calculate Return On Equity?

The formula for return on equity is:

Return on Equity = Net Profit ÷ Shareholders’ Equity

Or for Scales:

15% = 36.132 ÷ NZ$238m (Based on the trailing twelve months to June 2018.)

Most know that net profit is the total earnings after all expenses, but the concept of shareholders’ equity is a little more complicated. It is all the money paid into the company from shareholders, plus any earnings retained. Shareholders’ equity can be calculated by subtracting the total liabilities of the company from the total assets of the company.

What Does ROE Mean?

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 yearly profit. That means that the higher the ROE, the more profitable the company is. So, all else being equal, a high ROE is better than a low one. Clearly, then, one can use ROE to compare different companies.

Does Scales Have A Good ROE?

Arguably the easiest way to assess company’s ROE is to compare it with the average in 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, Scales has a better ROE than the average (8.5%) in the food industry.

That’s what I like to see. In my book, a high ROE almost always warrants a closer look. One data point to check is if insiders have bought shares recently.

Why You Should Consider Debt When Looking At 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.