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 State Auto Financial Corporation (NASDAQ:STFC), by way of a worked example.
Our data shows State Auto Financial has a return on equity of 5.7% for the last year. Another way to think of that is that for every $1 worth of equity in the company, it was able to earn $0.057.
Check out our latest analysis for State Auto Financial
How Do You Calculate ROE?
The formula for ROE is:
Return on Equity = Net Profit ÷ Shareholders' Equity
Or for State Auto Financial:
5.7% = US$52m ÷ US$916m (Based on the trailing twelve months to June 2019.)
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 earnings retained by the company, plus any capital paid in by shareholders. Shareholders' equity can be calculated by subtracting the total liabilities of the company from the total assets of the company.
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 equal, investors should like a high ROE. That means it can be interesting to compare the ROE of different companies.
Does State Auto Financial 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. The limitation of this approach is that some companies are quite different from others, even within the same industry classification. As shown in the graphic below, State Auto Financial has a lower ROE than the average (8.6%) in the Insurance industry classification.
That's not what we like to see. We prefer it when the ROE of a company is above the industry average, but it's not the be-all and end-all if it is lower. Nonetheless, it could be useful to double-check if insiders have sold shares recently.
Why You Should Consider Debt When Looking At ROE
Companies usually need to invest money to grow their profits. The cash for investment can come from prior year profits (retained earnings), issuing new shares, or borrowing. 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. Thus the use of debt can improve ROE, albeit along with extra risk in the case of stormy weather, metaphorically speaking.