Many investors are still learning about the various metrics that can be useful when analysing a stock. This article is for those who would like to learn about Return On Equity (ROE). We’ll use ROE to examine Sandfire Resources NL ( ASX:SFR ), by way of a worked example.
Over the last twelve months Sandfire Resources has recorded a ROE of 23% . One way to conceptualize this, is that for each A$1 of shareholders’ equity it has, the company made A$0.23 in profit.
Want to help shape the future of investing tools and platforms? Take the survey and be part of one of the most advanced studies of stock market investors to date.
How Do I Calculate Return On Equity?
The formula for ROE is:
Return on Equity = Net Profit ÷ Shareholders’ Equity
Or for Sandfire Resources:
23% = 123.024 ÷ AU$532m (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. You can calculate shareholders’ equity by subtracting the company’s total liabilities from its total assets.
What Does ROE 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. The higher the ROE, the more profit the company is making. So, all else being equal, a high ROE is better than a low one . That means ROE can be used to compare two businesses.
Does Sandfire Resources 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. Pleasingly, Sandfire Resources has a superior ROE than the average (13%) company in the Metals and Mining industry.
That is a good sign. We think a high ROE, alone, is usually enough to justify further research into a company. For example you might check if insiders are buying shares.
How Does Debt Impact ROE?
Companies usually need to invest money to grow their profits. That cash can come from retained earnings, issuing new shares (equity), or debt. In the first two cases, the ROE will capture this use of capital to grow. In the latter case, the use of debt will improve the returns, but will not change the equity. In this manner the use of debt will boost ROE, even though the core economics of the business stay the same.
Sandfire Resources’s Debt And Its 23% ROE
Sandfire Resources has a debt to equity ratio of just 0.0035, which is very low. The combination of modest debt and a very impressive ROE does suggest that the business is high quality. 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.
But It’s Just One Metric
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. All else being equal, a higher ROE is better.
But ROE is just one piece of a bigger puzzle, since high quality businesses often trade on high multiples of earnings. 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: Sandfire Resources 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 firstname.lastname@example.org .