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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 Iren SpA (BIT:IRE), by way of a worked example.
Iren has a ROE of 10%, based on the last twelve months. Another way to think of that is that for every €1 worth of equity in the company, it was able to earn €0.10.
Check out our latest analysis for Iren
How Do I Calculate ROE?
The formula for return on equity is:
Return on Equity = Net Profit ÷ Shareholders' Equity
Or for Iren:
10% = €239m ÷ €2.6b (Based on the trailing twelve months to March 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 earnings retained by the company, plus any capital paid in by shareholders. Shareholders' equity can be calculated by subtracting the total liabilities of the company from the total assets of the company.
What Does Return On Equity Mean?
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 Iren 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. The limitation of this approach is that some companies are quite different from others, even within the same industry classification. The image below shows that Iren has an ROE that is roughly in line with the Integrated Utilities industry average (10%).
That isn't amazing, but it is respectable. ROE tells us about the quality of the business, but it does not give us much of an idea if the share price is cheap. I will like Iren better if I see some big insider buys. While we wait, check out this free list of growing companies with considerable, recent, insider buying.
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 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. In this manner the use of debt will boost ROE, even though the core economics of the business stay the same.