One of the best investments we can make is in 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. We’ll use ROE to examine Phoslock Environmental Technologies Limited (ASX:PET), by way of a worked example.
Phoslock Environmental Technologies has a ROE of 0.8%, based on the last twelve months. One way to conceptualize this, is that for each A$1 of shareholders’ equity it has, the company made A$0.0077 in profit.
How Do I Calculate ROE?
The formula for ROE is:
Return on Equity = Net Profit ÷ Shareholders’ Equity
Or for Phoslock Environmental Technologies:
0.8% = AU$1k ÷ AU$14m (Based on the trailing twelve months to June 2018.)
Most readers would understand what net profit is, but it’s worth explaining the concept of shareholders’ equity. 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 Signify?
ROE looks at the amount a company earns relative to the money it has kept within the business. The ‘return’ is the yearly profit. 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. Clearly, then, one can use ROE to compare different companies.
Does Phoslock Environmental Technologies Have A Good ROE?
By comparing a company’s ROE with its industry average, we can get a quick measure of how good it is. However, this method is only useful as a rough check, because companies do differ quite a bit within the same industry classification. As shown in the graphic below, Phoslock Environmental Technologies has a lower ROE than the average (13%) in the commercial services industry classification.
That certainly isn’t ideal. We’d prefer see an ROE above the industry average, but it might not matter if the company is undervalued. Nonetheless, it might be wise to check if insiders have been selling.
How Does Debt Impact ROE?
Most companies need money — from somewhere — to grow their profits. That cash can come from issuing shares, retained earnings, or debt. In the first two cases, the ROE will capture this use of capital to grow. In the latter case, the use of debt will improve the returns, but will not change the equity. That will make the ROE look better than if no debt was used.
Phoslock Environmental Technologies’s Debt And Its 0.8% ROE
While Phoslock Environmental Technologies does have a tiny amount of debt, with debt to equity of just 0.022, we think the use of debt is very modest. Its ROE is certainly on the low side, and since it already uses debt, we’re not too excited about the company. Careful use of debt to boost returns is often very good for shareholders. However, it could reduce the company’s ability to take advantage of future opportunities.
But It’s Just One Metric
Return on equity is useful for comparing the quality of different businesses. In my book the highest quality companies have high return on equity, despite low debt. 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 when a business is high quality, the market often bids it up to a price that reflects this. 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 Phoslock Environmental Technologies by looking at this visualization of past earnings, revenue and cash flow.
Of course Phoslock Environmental Technologies may not be the best stock to buy. So you may wish to see this free collection of other companies that have high ROE 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@example.com.