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 Kallebäck Property Invest AB (publ) (STO:KAPIAB), by way of a worked example.

Over the last twelve months Kallebäck Property Invest has recorded a ROE of 8.0%. One way to conceptualize this, is that for each SEK1 of shareholders' equity it has, the company made SEK0.08 in profit.

Check out our latest analysis for Kallebäck Property Invest

How Do You Calculate ROE?

The formula for return on equity is:

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

Or for Kallebäck Property Invest:

8.0% = kr35m ÷ kr444m (Based on the trailing twelve months to June 2019.)

Most readers would understand what net profit is, but it’s worth explaining the concept of shareholders’ equity. It is the capital paid in by shareholders, plus any retained earnings. The easiest way to calculate shareholders' equity is to subtract the company's total liabilities from the 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 profit over the last twelve months. A higher profit will lead to a higher ROE. So, all else being equal, a high ROE is better than a low one. That means it can be interesting to compare the ROE of different companies.

Does Kallebäck Property Invest 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. The limitation of this approach is that some companies are quite different from others, even within the same industry classification. If you look at the image below, you can see Kallebäck Property Invest has a lower ROE than the average (13%) in the Real Estate industry classification.

That certainly isn't ideal. It is better when the ROE is above industry average, but a low one doesn't necessarily mean the business is overpriced. Nonetheless, it might be wise to check if insiders have been selling.

How Does Debt Impact Return On Equity?

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 used for growth will improve returns, but won't affect the total equity. In this manner the use of debt will boost ROE, even though the core economics of the business stay the same.

Combining Kallebäck Property Invest's Debt And Its 8.0% Return On Equity

Kallebäck Property Invest clearly uses a significant amount of debt to boost returns, as it has a debt to equity ratio of 1.10. 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.

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 around the same level of debt to equity, and one has a higher ROE, I'd generally prefer the one with higher ROE.

But ROE is just one piece of a bigger puzzle, since high quality businesses often trade on high multiples of earnings. The rate at which profits are likely to grow, relative to the expectations of profit growth reflected in the current price, must be considered, too. Check the past profit growth by Kallebäck Property Invest by looking at this visualization of past earnings, revenue and cash flow.

But note: Kallebäck Property Invest may not be the best stock to buy. So take a peek at this free list of interesting companies with high ROE and low debt.

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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