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 Entersoft S.A. (ATH:ENTER), by way of a worked example.
Our data shows Entersoft has a return on equity of 16% for the last year. One way to conceptualize this, is that for each €1 of shareholders' equity it has, the company made €0.16 in profit.
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How Do I Calculate Return On Equity?
The formula for return on equity is:
Return on Equity = Net Profit ÷ Shareholders' Equity
Or for Entersoft:
16% = €1.5m ÷ €9.7m (Based on the trailing twelve months to December 2018.)
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. You can calculate shareholders' equity by subtracting the company's total liabilities from its 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. The higher the ROE, the more profit the company is making. So, as a general rule, a high ROE is a good thing. That means ROE can be used to compare two businesses.
Does Entersoft Have A Good ROE?
By comparing a company's ROE with its industry average, we can get a quick measure of how good it is. However, this method is only useful as a rough check, because companies do differ quite a bit within the same industry classification. Pleasingly, Entersoft has a superior ROE than the average (6.5%) company in the Software industry.
That is a good sign. I usually take a closer look when a company has a better ROE than industry peers. For example, I often check if insiders have been buying shares .
The Importance Of Debt To 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 used for growth will improve returns, but won't affect the total equity. That will make the ROE look better than if no debt was used.
Entersoft's Debt And Its 16% ROE
While Entersoft does have some debt, with debt to equity of just 0.14, we wouldn't say debt is excessive. The fact that it achieved a fairly good ROE with only modest debt suggests the business might be worth putting on your watchlist. Judicious use of debt to improve returns can certainly be a good thing, although it does elevate risk slightly and reduce future optionality.