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. By way of learning-by-doing, we'll look at ROE to gain a better understanding of Smarttech247 Group plc (LON:S247).
Return on equity or ROE is an important factor to be considered by a shareholder because it tells them how effectively their capital is being reinvested. In simpler terms, it measures the profitability of a company in relation to shareholder's equity.
View our latest analysis for Smarttech247 Group
How Do You Calculate Return On Equity?
The formula for ROE is:
Return on Equity = Net Profit (from continuing operations) ÷ Shareholders' Equity
So, based on the above formula, the ROE for Smarttech247 Group is:
36% = €1.3m ÷ €3.5m (Based on the trailing twelve months to January 2022).
The 'return' refers to a company's earnings over the last year. Another way to think of that is that for every £1 worth of equity, the company was able to earn £0.36 in profit.
Does Smarttech247 Group 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. However, this method is only useful as a rough check, because companies do differ quite a bit within the same industry classification. As you can see in the graphic below, Smarttech247 Group has a higher ROE than the average (8.7%) in the Software industry.
That is a good sign. With that said, a high ROE doesn't always indicate high profitability. A higher proportion of debt in a company's capital structure may also result in a high ROE, where the high debt levels could be a huge risk .
The Importance Of Debt To Return On Equity
Virtually all companies need money to invest in the business, to grow profits. That cash can come from retained earnings, issuing new shares (equity), or debt. In the first two cases, the ROE will capture this use of capital to grow. In the latter case, the use of debt will improve the returns, but will not change the equity. That will make the ROE look better than if no debt was used.
Smarttech247 Group's Debt And Its 36% ROE
Although Smarttech247 Group does use debt, its debt to equity ratio of 0.66 is still low. The combination of modest debt and a very impressive ROE does suggest that the business is high quality. Conservative use of debt to boost returns is usually a good move for shareholders, though it does leave the company more exposed to interest rate rises.
Conclusion
Return on equity is a useful indicator of the ability of a business to generate profits and return them to shareholders. In our books, the highest quality companies have high return on equity, despite low debt. If two companies have around the same level of debt to equity, and one has a higher ROE, I'd generally prefer the one with higher ROE.