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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 Croma Security Solutions Group PLC (LON:CSSG).
Over the last twelve months Croma Security Solutions Group has recorded a ROE of 14%.
That means that for every £1 worth of shareholders’ equity, it generated £0.14 in profit.
How Do I Calculate Return On Equity?
The formula for return on equity is:
Return on Equity = Net Profit ÷ Shareholders’ Equity
Or for Croma Security Solutions Group:
14% = UK£1.6m ÷ UK£12m (Based on the trailing twelve months to December 2018.)
Most readers would understand what net profit is, but it’s worth explaining the concept of shareholders’ equity.
It is the capital paid in by shareholders, plus any retained earnings.
The easiest way to calculate shareholders’ equity is to subtract the company’s total liabilities from the total assets.
What Does Return On Equity 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 profit over the last twelve months.
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 Croma Security Solutions Group 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.
The limitation of this approach is that some companies are quite different from others, even within the same industry classification.
As is clear from the image below, Croma Security Solutions Group has a better ROE than the average (10%) in the Electronic industry.
That’s what I like to see.
I usually take a closer look when a company has a better ROE than industry peers.
For example, I often check if insiders have been buying shares .
How Does Debt Impact ROE?
Companies usually need to invest money to grow their 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.
In this manner the use of debt will boost ROE, even though the core economics of the business stay the same.
Combining Croma Security Solutions Group’s Debt And Its 14% Return On Equity
Croma Security Solutions Group is free of net debt, which is a positive for shareholders.
Its solid ROE indicates a good business, especially when you consider it is not using leverage.
At the end of the day, when a company has zero debt, it is in a better position to take future growth opportunities.
But It’s Just One Metric
Return on equity is useful for comparing the quality of different businesses.
Companies that can achieve high returns on equity without too much debt are generally of good quality.
If two companies have the same ROE, then I would generally prefer the one with less debt.
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.
Check the past profit growth by Croma Security Solutions Group by looking at this visualization 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 firstname.lastname@example.org. 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.
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