One of the best investments we can make is in our own knowledge and skill set. With that in mind, this article will work through how we can use Return On Equity (ROE) to better understand a business. To keep the lesson grounded in practicality, we'll use ROE to better understand SW Umwelttechnik Stoiser & Wolschner AG (VIE:SWUT).

SW Umwelttechnik Stoiser & Wolschner has a ROE of 55%, based on the last twelve months. That means that for every €1 worth of shareholders' equity, it generated €0.55 in profit.

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How Do You Calculate ROE?

The formula for ROE is:

Return on Equity = Net Profit ÷ Shareholders' Equity

Or for SW Umwelttechnik Stoiser & Wolschner:

55% = €4.6m ÷ €8.2m (Based on the trailing twelve months to December 2018.)

It's easy to understand the 'net profit' part of that equation, but 'shareholders' equity' requires further explanation. It is the capital paid in by shareholders, plus any retained earnings. You can calculate shareholders' equity by subtracting the company's total liabilities from its total assets.

What Does Return On Equity Mean?

ROE looks at the amount a company earns relative to the money it has kept within the business. 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 equal, investors should like a high ROE. Clearly, then, one can use ROE to compare different companies.

Does SW Umwelttechnik Stoiser & Wolschner Have A Good ROE?

Arguably the easiest way to assess company's ROE is to compare it with the average in its industry. However, this method is only useful as a rough check, because companies do differ quite a bit within the same industry classification. As you can see in the graphic below, SW Umwelttechnik Stoiser & Wolschner has a higher ROE than the average (12%) in the Construction 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 .

The Importance Of Debt To 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 case of the first and second options, the ROE will reflect this use of cash, for growth. In the latter case, the debt required for growth will boost returns, but will not impact the shareholders' equity. In this manner the use of debt will boost ROE, even though the core economics of the business stay the same.

SW Umwelttechnik Stoiser & Wolschner's Debt And Its 55% ROE

It seems that SW Umwelttechnik Stoiser & Wolschner uses a lot of debt to fund the business, since it has a high debt to equity ratio of 6.58. Its ROE is no doubt quite impressive, but it would probably be a lot lower without the use of significant leverage.

In Summary

Return on equity is one way we can compare the business quality of different companies. 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.

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

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.