One of the best investments we can make is graphql filter on nested fieldin 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. By way of learning-by-doing, we’ll look at ROE to gain a better understanding of S.M.R.E. S.p.A. (

BIT:SMR

).

Over the last twelve months

S.M.R.E has recorded a ROE of 1.4%

. That means that for every €1 worth of shareholders’ equity, it generated €0.014 in profit.

Check out our latest analysis for S.M.R.E

How Do You Calculate ROE?

The

formula for return on equity

is:

Return on Equity = Net Profit ÷ Shareholders’ Equity

Or for S.M.R.E:

1.4% = 0.119769 ÷ €21m (Based on the trailing twelve months to June 2018.)

It’s easy to understand the ‘net profit’ part of that equation, but ‘shareholders’ equity’ requires further explanation. It is the capital paid in by shareholders, plus any retained earnings. The easiest way to calculate shareholders’ equity is to subtract the company’s total liabilities from the 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 amount earned after tax over the last twelve months. That means that the higher the ROE, the more profitable the company is. So, all else equal,

investors should like a high ROE

. That means it can be interesting to compare the ROE of different companies.

Does S.M.R.E Have A Good ROE?

Arguably the easiest way to assess company’s ROE is to compare it with the average in its industry. However, this method is only useful as a rough check, because companies do differ quite a bit within the same industry classification. If you look at the image below, you can see S.M.R.E has a lower ROE than the average (14%) in the Machinery industry classification.

BIT:SMR Last Perf January 1st 19

Unfortunately, that’s sub-optimal. We’d prefer see an ROE above the industry average, but it might not matter if the company is undervalued. Nonetheless, it could be useful to

double-check if insiders have sold shares recently

.

How Does Debt Impact 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 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.

Story continues

S.M.R.E’s Debt And Its 1.4% ROE

S.M.R.E has a debt to equity ratio of 0.52, which is far from excessive. Its ROE is quite low, and the company already has some debt, so surely shareholders are hoping for an improvement. Conservative use of debt to boost returns is usually a good move for shareholders, though it does leave the company more exposed to interest rate rises.

The Bottom Line On ROE

Return on equity is useful for comparing the quality of different businesses. A company that can achieve a high return on equity without debt could be considered a high quality business. If two companies have around the same level of debt to equity, and one has a higher ROE, I’d generally prefer the one with higher ROE.

But ROE is just one piece of a bigger puzzle, since high quality businesses often trade on high multiples of earnings. It is important to consider other factors, such as future profit growth — and how much investment is required going forward. So you might want to take a peek at this

data-rich interactive graph of forecasts for the company

.

If you would prefer check out another company — one with potentially superior financials — then do not miss this

free

list of interesting companies, that have HIGH return on equity and low debt.

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

[email protected]

.

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