One of the best investments we can make is in our own knowledge and skill set. With that in mind, this article will work through how we can use Return On Equity (ROE) to better understand a business. To keep the lesson grounded in practicality, we’ll use ROE to better understand Next Fifteen Communications Group plc (LON:NFC).
Next Fifteen Communications Group has a ROE of 15%, based on the last twelve months. One way to conceptualize this, is that for each £1 of shareholders’ equity it has, the company made £0.15 in profit.
See our latest analysis for Next Fifteen Communications Group
Want to help shape the future of investing tools and platforms? Take the survey and be part of one of the most advanced studies of stock market investors to date.
How Do You Calculate ROE?
The formula for return on equity is:
Return on Equity = Net Profit ÷ Shareholders’ Equity
Or for Next Fifteen Communications Group:
15% = 12.531 ÷ UK£86m (Based on the trailing twelve months to July 2018.)
Most readers would understand what net profit is, but it’s worth explaining the concept of shareholders’ equity. It is the capital paid in by shareholders, plus any retained earnings. You can calculate shareholders’ equity by subtracting the company’s total liabilities from its total assets.
What Does Return On Equity Signify?
ROE measures a company’s profitability against the profit it retains, and any outside investments. The ‘return’ is the yearly profit. A higher profit will lead to a higher ROE. So, as a general rule, a high ROE is a good thing. That means ROE can be used to compare two businesses.
Does Next Fifteen Communications Group Have A Good Return On Equity?
One simple way to determine if a company has a good return on equity is to compare it to the average for its industry. The limitation of this approach is that some companies are quite different from others, even within the same industry classification. Pleasingly, Next Fifteen Communications Group has a superior ROE than the average (7.3%) company in the Media industry.
That’s clearly a positive. We think a high ROE, alone, is usually enough to justify further research into a company. One data point to check is if insiders have bought shares recently.
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 two cases, the ROE will capture this use of capital to grow. 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.