In This Article:
While some investors are already well versed in financial metrics (hat tip), this article is for those who would like to learn about Return On Equity (ROE) and why it is important. We'll use ROE to examine Indutrade AB (publ) (STO:INDT), by way of a worked example.
Over the last twelve months Indutrade has recorded a ROE of 22%. One way to conceptualize this, is that for each SEK1 of shareholders' equity it has, the company made SEK0.22 in profit.
See our latest analysis for Indutrade
How Do You Calculate ROE?
The formula for return on equity is:
Return on Equity = Net Profit ÷ Shareholders' Equity
Or for Indutrade:
22% = kr1.4b ÷ kr6.5b (Based on the trailing twelve months to June 2019.)
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. The easiest way to calculate shareholders' equity is to subtract the company's total liabilities from the total assets.
What Does Return On Equity Signify?
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 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. Clearly, then, one can use ROE to compare different companies.
Does Indutrade Have A Good ROE?
One simple way to determine if a company has a good return on equity is to compare it to the average for its industry. 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, Indutrade has a higher ROE than the average (17%) in the Trade Distributors industry.
That is a good sign. We think a high ROE, alone, is usually enough to justify further research into a company. For example you might check if insiders are buying shares.
How Does Debt Impact ROE?
Companies usually need to invest money to grow their profits. That cash can come from issuing shares, retained earnings, 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 used for growth will improve returns, but won't affect the total equity. Thus the use of debt can improve ROE, albeit along with extra risk in the case of stormy weather, metaphorically speaking.
Indutrade's Debt And Its 22% ROE
Indutrade clearly uses a significant amount of debt to boost returns, as it has a debt to equity ratio of 1.03. While the ROE is impressive, that metric has clearly benefited from the company's use of debt. Debt increases risk and reduces options for the company in the future, so you generally want to see some good returns from using it.