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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 Spectra Systems Corporation (LON:SPSC), by way of a worked example.
Our data shows Spectra Systems has a return on equity of 16% for the last year. One way to conceptualize this, is that for each £1 of shareholders' equity it has, the company made £0.16 in profit.
Check out our latest analysis for Spectra Systems
How Do I Calculate Return On Equity?
The formula for return on equity is:
Return on Equity = Net Profit ÷ Shareholders' Equity
Or for Spectra Systems:
16% = US$4.1m ÷ US$26m (Based on the trailing twelve months to December 2018.)
It's easy to understand the 'net profit' part of that equation, but 'shareholders' equity' requires further explanation. It is the capital paid in by shareholders, plus any retained earnings. You can calculate shareholders' equity by subtracting the company's total liabilities from its total assets.
What Does ROE Signify?
ROE looks at the amount a company earns relative to the money it has kept within the business. The 'return' is the amount earned after tax over the last twelve months. 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 ROE can be used to compare two businesses.
Does Spectra Systems Have A Good ROE?
Arguably the easiest way to assess company's ROE is to compare it with the average in its industry. The limitation of this approach is that some companies are quite different from others, even within the same industry classification. Pleasingly, Spectra Systems has a superior ROE than the average (12%) company in the Electronic industry.
That is a good sign. We think a high ROE, alone, is usually enough to justify further research into a company. For example, I often check if insiders have been buying shares .
How Does Debt Impact ROE?
Companies usually need to invest money 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. That will make the ROE look better than if no debt was used.