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 DATA MODUL Aktiengesellschaft, Produktion und Vertrieb von elektronischen Systemen (ETR:DAM), by way of a worked example.

DATA MODUL Produktion und Vertrieb von elektronischen Systemen has a ROE of 9.6%, based on the last twelve months. One way to conceptualize this, is that for each €1 of shareholders' equity it has, the company made €0.10 in profit.

View our latest analysis for DATA MODUL Produktion und Vertrieb von elektronischen Systemen

How Do You Calculate Return On Equity?

The formula for ROE is:

Return on Equity = Net Profit ÷ Shareholders' Equity

Or for DATA MODUL Produktion und Vertrieb von elektronischen Systemen:

9.6% = €9.4m ÷ €99m (Based on the trailing twelve months to September 2019.)

Most readers would understand what net profit is, but it’s worth explaining the concept of shareholders’ equity. It is all earnings retained by the company, plus any capital paid in by shareholders. You can calculate shareholders' equity by subtracting the company's total liabilities from its total assets.

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 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. Clearly, then, one can use ROE to compare different companies.

Does DATA MODUL Produktion und Vertrieb von elektronischen Systemen 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. However, this method is only useful as a rough check, because companies do differ quite a bit within the same industry classification. The image below shows that DATA MODUL Produktion und Vertrieb von elektronischen Systemen has an ROE that is roughly in line with the Electronic industry average (9.7%).

That isn't amazing, but it is respectable. ROE doesn't tell us if the share price is low, but it can inform us to the nature of the business. For those looking for a bargain, other factors may be more important. For those who like to find winning investments this free list of growing companies with recent insider purchasing, could be just the ticket.

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 debt required for growth will boost returns, but will not impact the shareholders' equity. Thus the use of debt can improve ROE, albeit along with extra risk in the case of stormy weather, metaphorically speaking.

Combining DATA MODUL Produktion und Vertrieb von elektronischen Systemen's Debt And Its 9.6% Return On Equity

While DATA MODUL Produktion und Vertrieb von elektronischen Systemen does have a tiny amount of debt, with debt to equity of just 0.043, we think the use of debt is very modest. The combination of modest debt and a very respectable ROE suggests this is a business worth watching. Careful use of debt to boost returns is often very good for shareholders. However, it could reduce the company's ability to take advantage of future opportunities.

The Key Takeaway

Return on equity is one way we can compare the business quality of different companies. Companies that can achieve high returns on equity without too much debt are generally of good quality. All else being equal, a higher ROE is better.

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 take a peek at this data-rich interactive graph of forecasts for the company.

But note: DATA MODUL Produktion und Vertrieb von elektronischen Systemen 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.

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. Thank you for reading.