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Many investors are still learning about the various metrics that can be useful when analysing a stock. This article is for those who would like to learn about Return On Equity (ROE). We'll use ROE to examine Resource Development Group Limited (ASX:RDG), by way of a worked example.
Return on equity or ROE is a key measure used to assess how efficiently a company's management is utilizing the company's capital. Put another way, it reveals the company's success at turning shareholder investments into profits.
See our latest analysis for Resource Development Group
How Do You Calculate Return On Equity?
The formula for ROE is:
Return on Equity = Net Profit (from continuing operations) ÷ Shareholders' Equity
So, based on the above formula, the ROE for Resource Development Group is:
1.4% = AU$1.2m ÷ AU$87m (Based on the trailing twelve months to December 2021).
The 'return' refers to a company's earnings over the last year. That means that for every A$1 worth of shareholders' equity, the company generated A$0.01 in profit.
Does Resource Development Group 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. If you look at the image below, you can see Resource Development Group has a lower ROE than the average (12%) in the Construction industry classification.
Unfortunately, that's sub-optimal. That being said, a low ROE is not always a bad thing, especially if the company has low leverage as this still leaves room for improvement if the company were to take on more debt. A high debt company having a low ROE is a different story altogether and a risky investment in our books. To know the 2 risks we have identified for Resource Development Group visit our risks dashboard for free.
How Does Debt Impact Return On Equity?
Virtually all companies need money to invest in the business, to grow profits. The cash for investment can come from prior year profits (retained earnings), issuing new shares, or borrowing. In the first two cases, the ROE will capture this use of capital to grow. In the latter case, the use of debt will improve the returns, but will not change the equity. In this manner the use of debt will boost ROE, even though the core economics of the business stay the same.
Resource Development Group's Debt And Its 1.4% ROE
Resource Development Group has a debt to equity ratio of 0.21, which is far from excessive. Its ROE is rather low, and it does use some debt, albeit not much. That's not great to see. Careful use of debt to boost returns is often very good for shareholders. However, it could reduce the company's ability to take advantage of future opportunities.