One of the best investments we can make is spiritual roots of adhdin 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 Biosearch, S.A. (

BME:BIO

).

Over the last twelve months

Biosearch has recorded a ROE of 14%

. One way to conceptualize this, is that for each €1 of shareholders’ equity it has, the company made €0.14 in profit.

See our latest analysis for Biosearch

How Do I Calculate Return On Equity?

The

formula for return on equity

is:

Return on Equity = Net Profit ÷ Shareholders’ Equity

Or for Biosearch:

14% = 3.144 ÷ €22m (Based on the trailing twelve months to June 2018.)

It’s easy to understand the ‘net profit’ part of that equation, but ‘shareholders’ equity’ requires further explanation. 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 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. A higher profit will lead to a higher ROE. So, all else equal,

investors should like a high ROE

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

Does Biosearch Have A Good Return On Equity?

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. If you look at the image below, you can see Biosearch has a similar ROE to the average in the Biotechs industry classification (17%).

BME:BIO Last Perf January 1st 19

That’s not overly surprising. ROE tells us about the quality of the business, but it does not give us much of an idea if the share price is cheap. If you are like me, then you will

not

want to miss this

free

list of growing companies that insiders are buying.

How Does Debt Impact ROE?

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 first two cases, the ROE will capture this use of capital to grow. 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.

Story continues

Biosearch’s Debt And Its 14% ROE

Although Biosearch does use debt, its debt to equity ratio of 0.20 is still low. The fact that it achieved a fairly good ROE with only modest debt suggests the business might be worth putting on your watchlist. 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 a useful indicator of the ability of a business to generate profits and return them to shareholders. Companies that can achieve high returns on equity without too much debt are generally of good quality. 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 when a business is high quality, the market often bids it up to a price that reflects this. 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 I think it may be worth checking this

free

this

detailed graph

of past earnings, revenue and cash flow

.

But note:

Biosearch 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.

To help readers see past the short term volatility of the financial market, we aim to bring you a long-term focused research analysis purely driven by fundamental data. Note that our analysis does not factor in the latest price-sensitive company announcements.

The author is an independent contributor and at the time of publication had no position in the stocks mentioned. For errors that warrant correction please contact the editor at

[email protected]

.

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