In This Article:
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. To keep the lesson grounded in practicality, we'll use ROE to better understand Timah Resources Limited (ASX:TML).
Timah Resources has a ROE of 19%, based on the last twelve months. That means that for every A$1 worth of shareholders' equity, it generated A$0.19 in profit.
Check out our latest analysis for Timah Resources
How Do You Calculate ROE?
The formula for ROE is:
Return on Equity = Net Profit ÷ Shareholders' Equity
Or for Timah Resources:
19% = RM3.7m ÷ RM19m (Based on the trailing twelve months to June 2019.)
Most readers would understand what net profit is, but it’s worth explaining the concept of shareholders’ equity. It is the capital paid in by shareholders, plus any retained earnings. The easiest way to calculate shareholders' equity is to subtract the company's total liabilities from the 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 profit over the last twelve months. That means that the higher the ROE, the more profitable the company is. So, as a general rule, a high ROE is a good thing. Clearly, then, one can use ROE to compare different companies.
Does Timah Resources 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. Pleasingly, Timah Resources has a superior ROE than the average (8.0%) company in the Renewable Energy industry.
That's clearly a positive. I usually take a closer look when a company has a better ROE than industry peers. For example you might check if insiders are buying shares.
How Does Debt Impact ROE?
Most companies need money -- from somewhere -- to grow their 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 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.
Timah Resources's Debt And Its 19% ROE
It's worth noting the significant use of debt by Timah Resources, leading to its debt to equity ratio of 2.63. while its ROE is respectable, it is worth keeping in mind that there is usually a limit to how much debt a company can use. Investors should think carefully about how a company might perform if it was unable to borrow so easily, because credit markets do change over time.