Many investors are still learning about the various metrics that can be useful when analysing a stock. This article is for those who would like to learn about Return On Equity (ROE). We'll use ROE to examine Catena Media plc (STO:CTM), by way of a worked example.
Our data shows Catena Media has a return on equity of 19% for the last year. One way to conceptualize this, is that for each SEK1 of shareholders' equity it has, the company made SEK0.19 in profit.
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How Do I Calculate ROE?
The formula for return on equity is:
Return on Equity = Net Profit ÷ Shareholders' Equity
Or for Catena Media:
19% = €28m ÷ €149m (Based on the trailing twelve months to March 2019.)
It's easy to understand the 'net profit' part of that equation, but 'shareholders' equity' requires further explanation. It is all earnings retained by the company, plus any capital paid in by shareholders. The easiest way to calculate shareholders' equity is to subtract the company's total liabilities from the total assets.
What Does Return On Equity Mean?
ROE measures a company's profitability against the profit it retains, and any outside investments. 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 being equal, a high ROE is better than a low one. That means ROE can be used to compare two businesses.
Does Catena Media Have A Good Return On Equity?
Arguably the easiest way to assess company's ROE is to compare it with the average in its industry. The limitation of this approach is that some companies are quite different from others, even within the same industry classification. The image below shows that Catena Media has an ROE that is roughly in line with the Interactive Media and Services industry average (18%).
That's neither particularly good, nor bad. ROE can give us a view about company quality, but many investors also look to other factors, such as whether there are insiders buying shares. For those who like to find winning investments this free list of growing companies with recent insider purchasing, could be just the ticket.
The Importance Of Debt To Return On Equity
Most companies need money -- from somewhere -- 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. That will make the ROE look better than if no debt was used.
Combining Catena Media's Debt And Its 19% Return On Equity
Catena Media does use a significant amount of debt to increase returns. It has a debt to equity ratio of 1.04. There's no doubt the ROE is respectable, but it's worth keeping in mind that metric is elevated 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 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.
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. Profit growth rates, versus the expectations reflected in the price of the stock, are a particularly important to consider. So you might want to check this FREE visualization of analyst forecasts for the company.
Of course Catena Media 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 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. Thank you for reading.