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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. By way of learning-by-doing, we’ll look at ROE to gain a better understanding of Afone S.A. (
EPA:AFO ). Over the last twelve months Afone has recorded a ROE of 32% . That means that for every €1 worth of shareholders’ equity, it generated €0.32 in profit. Check out our latest analysis for Afone How Do You Calculate ROE? The formula for return on equity is: Return on Equity = Net Profit ÷ Shareholders’ Equity Or for Afone: 32% = 10.903 ÷ €34m (Based on the trailing twelve months to June 2018.) 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. You can calculate shareholders’ equity by subtracting the company’s total liabilities from its total assets. What Does Return On Equity Mean? 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. The higher the ROE, the more profit the company is making. 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 Afone Have A Good ROE? 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. As is clear from the image below, Afone has a better ROE than the average (16%) in the Telecom industry. ENXTPA:AFO Last Perf February 1st 19 That is a good sign. 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 Companies usually need to invest money to grow their profits. That cash can come from issuing shares, retained earnings, or debt. In the case of the first and second options, the ROE will reflect this use of cash, for growth. 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. Story continues Afone’s Debt And Its 32% ROE Afone has a debt to equity ratio of 0.13, which is far from excessive. 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. In Summary Return on equity is a useful indicator of the ability of a business to generate profits and return them to shareholders. A company that can achieve a high return on equity without debt could be considered a high quality business. If two companies have the same ROE, then I would generally prefer the one with less debt. Having said that, while ROE is a useful indicator of business quality, you’ll have to look at a whole range of factors to determine the right price to buy a stock. Profit growth rates, versus the expectations reflected in the price of the stock, are a particularly important to consider. Check the past profit growth by Afone by looking at this visualization of past earnings, revenue and cash flow . Of course, you might find a fantastic investment by looking elsewhere. So take a peek at this free list of interesting companies. To help readers see past the short term volatility of the financial market, we aim to bring you a long-term focused research analysis purely driven by fundamental data. Note that our analysis does not factor in the latest price-sensitive company announcements. The author is an independent contributor and at the time of publication had no position in the stocks mentioned. For errors that warrant correction please contact the editor at . View comments |
