One of the best investments we can make is in our own knowledge and skills. With that in mind, this article will discuss how we can use Return on Equity (ROE) to better understand a business. As a learning by doing, we will look at the ROE to better understand Simteract SA (WSE: SMT).
Return on equity or ROE is a key metric used to assess the efficiency with which the management of a business is using business capital. In simpler terms, it measures a company’s profitability relative to equity.
See our latest review for Simteract
How is the ROE calculated?
The return on equity formula is:
Return on equity = Net income (from continuing operations) ÷ Equity
So, based on the above formula, Simteract’s ROE is:
2.9% = zł189k zł6.5m (Based on the last twelve months up to September 2021).
The “return” is the profit of the last twelve months. So this means that for every PLN1 of its shareholders’ investments, the company generates a profit of PLN0.03.
Does Simteract have a good ROE?
By comparing a company’s ROE with its industry average, we can get a quick measure of its quality. However, this method is only useful as a rough check, as companies differ a lot within the same industry classification. As shown in the image below, Simteract has a lower than average ROE (21%) for the entertainment industry.
This is not what we like to see. However, we believe that a lower ROE could still mean that a company has the opportunity to improve its returns through the use of leverage, provided its existing leverage levels are low. When a company has a low ROE but high levels of debt, we would be careful because the risk involved is too high. To find out about the 5 risks we have identified for Simteract, visit our free risk dashboard.
The importance of debt to return on equity
Most businesses need money – from somewhere – to increase their profits. This liquidity can come from the issuance of shares, retained earnings or debt. In the first and second cases, the ROE will reflect this use of cash for investing in the business. In the latter case, the use of debt will improve returns, but will not affect equity. This will make the ROE better than if no debt was used.
Combine Simteract’s debt and its return on equity of 2.9%
Although Simteract uses quite a bit of debt, its debt-to-equity ratio of just 0.0072 is very low. Its ROE is quite low and the company already has some debt, so shareholders are surely hoping for improvement. Using debt wisely to improve returns can certainly be a good thing, even if it slightly increases risk and lowers future option.
Return on equity is a way to compare the business quality of different companies. In our books, the highest quality companies have a high return on equity, despite low leverage. All other things being equal, a higher ROE is preferable.
But when a company is of high quality, the market often offers it up to a price that reflects that. It is important to take into account other factors, such as future profit growth and the amount of investment required for the future. You can see how the business has grown in the past by checking out this FREE detailed graphic past earnings, income and cash flow.
Sure Simteract may not be the best stock to buy. So you might want to see this free collection of other companies with high ROE and low leverage.
This Simply Wall St article is general in nature. We provide commentary based on historical data and analyst forecasts using only unbiased methodology and our articles are not intended to be financial advice. It does not constitute a recommendation to buy or sell shares and does not take into account your goals or your financial situation. Our aim is to bring you long-term, targeted analysis based on fundamental data. Note that our analysis may not take into account the latest announcements from price sensitive companies or qualitative documents. Simply Wall St has no position in any of the stocks mentioned.
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