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. We'll use ROE to examine Altareit SCA (EPA:AREIT), by way of a worked example.

Altareit has a ROE of 34%, based on the last twelve months. Another way to think of that is that for every €1 worth of equity in the company, it was able to earn €0.34.

Want to participate in a short research study? Help shape the future of investing tools and you could win a $250 gift card!

See our latest analysis for Altareit

How Do You Calculate Return On Equity?

The formula for return on equity is:

Return on Equity = Net Profit ÷ Shareholders' Equity

Or for Altareit:

34% = €273m ÷ €843m (Based on the trailing twelve months to December 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 the money paid into the company from shareholders, plus any earnings retained. You can calculate shareholders' equity by subtracting the company's total liabilities from its total assets.

What Does ROE Mean?

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 yearly profit. The higher the ROE, the more profit the company is making. So, as a general rule, a high ROE is a good thing. Clearly, then, one can use ROE to compare different companies.

Does Altareit 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. The limitation of this approach is that some companies are quite different from others, even within the same industry classification. Pleasingly, Altareit has a superior ROE than the average (10%) company in the Real Estate industry.

That is a good sign. In my book, a high ROE almost always warrants a closer look. For example, I often check if insiders have been buying shares .

How Does Debt Impact Return On Equity?

Virtually all companies need money to invest in the business, to grow 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.

Altareit's Debt And Its 34% ROE

It's worth noting the significant use of debt by Altareit, leading to its debt to equity ratio of 1.19. I think the ROE is impressive, but it would have been assisted by the use of debt. Investors should think carefully about how a company might perform if it was unable to borrow so easily, because credit markets do change over time.

But It's Just One Metric

Return on equity is a useful indicator of the ability of a business to generate profits and return them to shareholders. Companies that can achieve high returns on equity without too much debt are generally of good quality. 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.

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. It is important to consider other factors, such as future profit growth -- and how much investment is required going forward. You can see how the company has grow in the past by looking at this FREE detailed graph of past earnings, revenue and cash flow.

Of course Altareit 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.

We aim to bring you long-term focused research analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material.

If you spot an error that warrants correction, please contact the editor at editorial-team@simplywallst.com. 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. Thank you for reading.