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 Inclam, S.A. (BME:INC), by way of a worked example.

Inclam has a ROE of 16%, 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 €0.16.

See our latest analysis for Inclam

How Do You Calculate ROE?

The formula for ROE is:

Return on Equity = Net Profit (from continuing operations) ÷ Shareholders' Equity

Or for Inclam:

16% = €1.7m ÷ €11m (Based on the trailing twelve months to June 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. Shareholders' equity can be calculated by subtracting the total liabilities of the company from the total assets of the company.

What Does ROE Signify?

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 profit 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 Inclam Have A Good ROE?

One simple way to determine if a company has a good return on equity is to compare it to the average for its industry. Importantly, this is far from a perfect measure, because companies differ significantly within the same industry classification. Pleasingly, Inclam has a superior ROE than the average (9.9%) company in the Commercial Services industry.

That's what I like to see. I usually take a closer look when a company has a better ROE than industry peers. For example you might check if insiders are buying shares.

Why You Should Consider Debt When Looking At ROE

Companies usually need to invest money to grow their profits. That cash can come from issuing shares, retained earnings, 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 use of debt will improve the returns, but will not change the equity. In this manner the use of debt will boost ROE, even though the core economics of the business stay the same.

Combining Inclam's Debt And Its 16% Return On Equity

Inclam has a debt to equity ratio of 0.86, which is far from excessive. Its very respectable ROE, combined with only modest debt, suggests the business is in good shape. Conservative use of debt to boost returns is usually a good move for shareholders, though it does leave the company more exposed to interest rate rises.

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 the same ROE, then I would generally prefer the one with less debt.

But ROE is just one piece of a bigger puzzle, since high quality businesses often trade on high multiples of earnings. 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 Inclam by looking at this visualization of past earnings, revenue and cash flow.

Of course, you might find a fantastic investment by looking elsewhere. So take a peek at this free list of interesting companies.

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.

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