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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 Bega Cheese Limited (ASX:BGA), by way of a worked example.
Over the last twelve months Bega Cheese has recorded a ROE of 1.4%. That means that for every A$1 worth of shareholders' equity, it generated A$0.01 in profit.
See our latest analysis for Bega Cheese
How Do You Calculate Return On Equity?
The formula for return on equity is:
Return on Equity = Net Profit ÷ Shareholders' Equity
Or for Bega Cheese:
1.4% = AU$12m ÷ AU$826m (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 ROE Signify?
ROE measures a company's profitability against the profit it retains, and any outside investments. The 'return' is the profit over the last twelve months. That means that the higher the ROE, the more profitable the company is. So, all else being equal, a high ROE is better than a low one. That means ROE can be used to compare two businesses.
Does Bega Cheese 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. As shown in the graphic below, Bega Cheese has a lower ROE than the average (7.1%) in the Food industry classification.
That's not what we like to see. It is better when the ROE is above industry average, but a low one doesn't necessarily mean the business is overpriced. Nonetheless, it might be wise to check if insiders have been selling.
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 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.
Bega Cheese's Debt And Its 1.4% ROE
While Bega Cheese does have some debt, with debt to equity of just 0.38, we wouldn't say debt is excessive. Its ROE is rather low, and it does use some debt, albeit not much. That's not great to see. Judicious use of debt to improve returns can certainly be a good thing, although it does elevate risk slightly and reduce future optionality.