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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 FLSmidth & Co. A/S (CPH:FLS), by way of a worked example.
Our data shows FLSmidth has a return on equity of 9.9% for the last year. Another way to think of that is that for every DKK1 worth of equity in the company, it was able to earn DKK0.099.
Check out our latest analysis for FLSmidth
How Do You Calculate ROE?
The formula for return on equity is:
Return on Equity = Net Profit ÷ Shareholders' Equity
Or for FLSmidth:
9.9% = ø818m ÷ ø8.2b (Based on the trailing twelve months to March 2019.)
Most readers would understand what net profit is, but it’s worth explaining the concept of shareholders’ equity. 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 Return On Equity 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 yearly profit. The higher the ROE, the more profit the company is making. So, all else equal, investors should like a high ROE. Clearly, then, one can use ROE to compare different companies.
Does FLSmidth 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. Importantly, this is far from a perfect measure, because companies differ significantly within the same industry classification. As you can see in the graphic below, FLSmidth has a higher ROE than the average (6.9%) in the Machinery industry.
That is a good sign. We think a high ROE, alone, is usually enough to justify further research into a company. For example you might check if insiders are buying shares.
How Does Debt Impact Return On Equity?
Most companies need money -- from somewhere -- to grow their profits. The cash for investment can come from prior year profits (retained earnings), issuing new shares, or borrowing. In the first and second cases, the ROE will reflect this use of cash for investment in the business. 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.