In This Article:
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 Medusa Mining Limited (ASX:MML), by way of a worked example.
Medusa Mining has a ROE of 29%, based on the last twelve months. That means that for every A$1 worth of shareholders' equity, it generated A$0.29 in profit.
View our latest analysis for Medusa Mining
How Do I Calculate ROE?
The formula for ROE is:
Return on Equity = Net Profit ÷ Shareholders' Equity
Or for Medusa Mining:
29% = US$36m ÷ US$124m (Based on the trailing twelve months to June 2019.)
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?
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. That means that the higher the ROE, the more profitable the company is. So, as a general rule, a high ROE is a good thing. Clearly, then, one can use ROE to compare different companies.
Does Medusa Mining Have A Good ROE?
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. As you can see in the graphic below, Medusa Mining has a higher ROE than the average (13%) in the Metals and Mining industry.
That's what I like to see. In my book, a high ROE almost always warrants a closer look. One data point to check is if insiders have bought shares recently.
Why You Should Consider Debt When Looking At ROE
Virtually all companies need money to invest in the business, to grow 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 required for growth will boost returns, but will not impact the shareholders' equity. In this manner the use of debt will boost ROE, even though the core economics of the business stay the same.
Medusa Mining's Debt And Its 29% ROE
Medusa Mining has a debt to equity ratio of just 0.055, which is very low. The combination of modest debt and a very impressive ROE does suggest that the business is high quality. Judicious use of debt to improve returns can certainly be a good thing, although it does elevate risk slightly and reduce future optionality.