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. To keep the lesson grounded in practicality, we'll use ROE to better understand Boral Limited (ASX:BLD).
Over the last twelve months Boral has recorded a ROE of 7.6%. One way to conceptualize this, is that for each A$1 of shareholders' equity it has, the company made A$0.076 in profit.
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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 Boral:
7.6% = AU$455m ÷ AU$5.9b (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. Shareholders' equity can be calculated by subtracting the total liabilities of the company from the total assets of the company.
What Does Return On Equity Mean?
ROE looks at the amount a company earns relative to the money it has kept within the business. The 'return' is the yearly profit. A higher profit will lead to a higher ROE. So, all else equal, investors should like a high ROE. That means it can be interesting to compare the ROE of different companies.
Does Boral Have A Good Return On Equity?
Arguably the easiest way to assess company's ROE is to compare it with the average in its industry. Importantly, this is far from a perfect measure, because companies differ significantly within the same industry classification. As shown in the graphic below, Boral has a lower ROE than the average (11%) in the Basic Materials 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. Still, shareholders might want to check if insiders have been selling.
How Does Debt Impact Return On Equity?
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 case of the first and second options, the ROE will reflect this use of cash, for growth. 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.
Boral's Debt And Its 7.6% ROE
Boral has a debt to equity ratio of 0.40, which is far from excessive. I'm not impressed with its ROE, but the debt levels are not too high, indicating the business has decent prospects. Judicious use of debt to improve returns can certainly be a good thing, although it does elevate risk slightly and reduce future optionality.