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 A2B Australia Limited (ASX:A2B), by way of a worked example.
A2B Australia has a ROE of 7.2%, based on the last twelve months. Another way to think of that is that for every A$1 worth of equity in the company, it was able to earn A$0.072.
Check out our latest analysis for A2B Australia
How Do I Calculate ROE?
The formula for ROE is:
Return on Equity = Net Profit ÷ Shareholders' Equity
Or for A2B Australia:
7.2% = AU$12m ÷ AU$164m (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 the money paid into the company from shareholders, plus any earnings retained. 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 amount earned after tax over the last twelve months. That means that the higher the ROE, the more profitable the company is. So, all else equal, investors should like a high ROE. Clearly, then, one can use ROE to compare different companies.
Does A2B Australia Have A Good ROE?
Arguably the easiest way to assess company's ROE is to compare it with the average in 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, A2B Australia has a lower ROE than the average (10%) in the Transportation 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 might be wise to check if insiders have been selling.
The Importance Of Debt To Return On Equity
Companies usually need to invest money to grow their profits. That cash can come from retained earnings, issuing new shares (equity), 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.