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. By way of learning-by-doing, we'll look at ROE to gain a better understanding of Tethys Oil AB (publ) (STO:TETY).

Over the last twelve months Tethys Oil has recorded a ROE of 21%. Another way to think of that is that for every SEK1 worth of equity in the company, it was able to earn SEK0.21.

See our latest analysis for Tethys Oil

How Do You Calculate ROE?

The formula for return on equity is:

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

Or for Tethys Oil:

21% = US$59m ÷ US$273m (Based on the trailing twelve months to September 2019.)

Most know that net profit is the total earnings after all expenses, but the concept of shareholders' equity is a little more complicated. It is all the money paid into the company from shareholders, plus any earnings retained. Shareholders' equity can be calculated by subtracting the total liabilities of the company from the total assets of the company.

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 yearly profit. The higher the ROE, the more profit the company is making. So, all else equal, investors should like a high ROE. Clearly, then, one can use ROE to compare different companies.

Does Tethys Oil Have A Good Return On Equity?

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. As you can see in the graphic below, Tethys Oil has a higher ROE than the average (10%) in the Oil and Gas industry.

That's what I like to see. In my book, a high ROE almost always warrants a closer look. For example you might check if insiders are buying shares.

The Importance Of Debt To 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.

Tethys Oil's Debt And Its 21% ROE

One positive for shareholders is that Tethys Oil does not have any net debt! Its impressive ROE suggests it is a high quality business, but it's even better to have achieved that without leverage. After all, when a company has a strong balance sheet, it can often find ways to invest in growth, even if it takes some time.

But It's Just One Metric

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. 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. 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. So you might want to take a peek at this data-rich interactive graph of forecasts for the company.

But note: Tethys Oil 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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