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. To keep the lesson grounded in practicality, we’ll use ROE to better understand Link Prop Investment AB (publ) (STO:LINKAB).
Over the last twelve months Link Prop Investment has recorded a ROE of 8.4%. That means that for every SEK1 worth of shareholders’ equity, it generated SEK0.08 in profit.
How Do You Calculate ROE?
The formula for return on equity is:
Return on Equity = Net Profit (from continuing operations) ÷ Shareholders’ Equity
Or for Link Prop Investment:
8.4% = kr11m ÷ kr127m (Based on the trailing twelve months to December 2019.)
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 the money paid into the company from shareholders, plus any earnings retained. The easiest way to calculate shareholders’ equity is to subtract the company’s total liabilities from the 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, as a general rule, a high ROE is a good thing. That means ROE can be used to compare two businesses.
Does Link Prop Investment 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. If you look at the image below, you can see Link Prop Investment has a lower ROE than the average (13%) in the Real Estate industry classification.
That certainly isn’t ideal. We prefer it when the ROE of a company is above the industry average, but it’s not the be-all and end-all if it is lower. 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. The cash for investment can come from prior year profits (retained earnings), issuing new shares, or borrowing. 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 required for growth will boost returns, but will not impact the shareholders’ equity. That will make the ROE look better than if no debt was used.
Link Prop Investment’s Debt And Its 8.4% ROE
It’s worth noting the significant use of debt by Link Prop Investment, leading to its debt to equity ratio of 1.31. There’s no doubt the ROE is respectable, but it’s worth keeping in mind that metric is elevated by the use of debt. Debt increases risk and reduces options for the company in the future, so you generally want to see some good returns from using it.
The Key Takeaway
Return on equity is one way we can compare the business quality of different companies. In my book the highest quality companies have high return on equity, despite low debt. If two companies have the same ROE, then I would generally prefer the one with less debt.
But when a business is high quality, the market often bids it up to a price that reflects this. It is important to consider other factors, such as future profit growth — and how much investment is required going forward. Check the past profit growth by Link Prop Investment by looking at this visualization of past earnings, revenue and cash flow.
Of course Link Prop Investment 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.
If you spot an error that warrants correction, please contact the editor at firstname.lastname@example.org. This article by Simply Wall St is general in nature. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. Simply Wall St has no position in the stocks mentioned.
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