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. We’ll use ROE to examine TTL Beteiligungs- und Grundbesitz-AG (FRA:TTO), by way of a worked example.
TTL Beteiligungs- und Grundbesitz-AG has a ROE of 5.0%, based on the last twelve months. Another way to think of that is that for every €1 worth of equity in the company, it was able to earn €0.050.
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How Do I Calculate ROE?
The formula for return on equity is:
Return on Equity = Net Profit ÷ Shareholders’ Equity
Or for TTL Beteiligungs- und Grundbesitz-AG:
5.0% = €2m ÷ €45m (Based on the trailing twelve months to June 2018.)
It’s easy to understand the ‘net profit’ part of that equation, but ‘shareholders’ equity’ requires further explanation. It is all earnings retained by the company, plus any capital paid in by shareholders. The easiest way to calculate shareholders’ equity is to subtract the company’s total liabilities from the total assets.
What Does ROE 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 profit over the last twelve months. A higher profit will lead to a a higher ROE. So, all else equal, investors should like a high ROE. That means ROE can be used to compare two businesses.
Does TTL Beteiligungs- und Grundbesitz-AG 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. The limitation of this approach is that some companies are quite different from others, even within the same industry classification. If you look at the image below, you can see TTL Beteiligungs- und Grundbesitz-AG has a lower ROE than the average (18%) in the it industry classification.
Unfortunately, that’s sub-optimal. 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.
The Importance Of Debt To Return On Equity
Most companies need money — from somewhere — to grow their 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 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.