One of the best investments we can make is in our own knowledge and skills. With that in mind, this article will discuss how we can use Return on Equity (ROE) to better understand a business. As a learning by doing, we will look at the ROE to better understand Netwise SA (WSE: NTW).
Return on equity or ROE is a key metric used to assess the efficiency with which the management of a business is using business capital. In short, the ROE shows the profit that each dollar generates compared to the investments of its shareholders.
Check out our latest analysis for Netwise
How to calculate return on equity?
ROE can be calculated using the formula:
Return on equity = Net income (from continuing operations) Ã· Equity
So, based on the above formula, Netwise’s ROE is:
44% = zÅ2.6m zÅ5.9m (Based on the last twelve months up to September 2020).
âReturnâ refers to a company’s profits over the past year. One way to conceptualize this is that for every PLN1 of share capital it has, the company has made a profit of PLN0.44.
Does Netwise have a good ROE?
By comparing a company’s ROE with its industry average, we can get a quick measure of its quality. The limitation of this approach is that some companies are very different from others, even within the same industry classification. Fortunately, Netwise has an above-average ROE (15%) for the IT industry.
This is clearly a positive point. However, keep in mind that a high ROE does not necessarily indicate efficient profit generation. Especially when a business uses high levels of leverage to finance its debt, which can increase its ROE, but high leverage puts the business at risk. Our risk dashboard should include the 3 risks that we have identified for Netwise.
What is the impact of debt on ROE?
Most businesses need money – from somewhere – to increase their profits. The money for the investment can come from the profits of the previous year (retained earnings), from the issuance of new shares or from loans. In the first and second cases, the ROE will reflect this use of cash for investing in the business. In the latter case, the debt used for growth will improve returns, but will not affect total equity. So, using debt can improve ROE, but with added risk in stormy weather, metaphorically speaking.
Netwise’s debt and its ROE of 44%
Netwise is net debt free, which is good for shareholders. Its impressive ROE suggests that this is a high-quality business, but it’s even better to get there without leverage. Ultimately, when a business has zero debt, it is in a better position to seize future growth opportunities.
Return on equity is a way to compare the business quality of different companies. A business that can earn a high return on equity without going into debt can be considered a high quality business. All other things being equal, a higher ROE is preferable.
That said, while ROE is a useful indicator of how good a business is, you’ll need to look at a whole range of factors to determine the right price to buy a stock. The rate at which earnings are likely to grow, relative to earnings growth expectations reflected in the current price, should also be considered. Check out Netwise’s past earnings growth by looking at this visualization of past earnings, revenue, and cash flow.
But beware : Netwise may not be the best stock to buy. So take a look at this free list of interesting companies with high ROE and low debt.
This Simply Wall St article is general in nature. We provide commentary based on historical data and analyst forecasts using only unbiased methodology and our articles are not intended to be financial advice. It does not constitute a recommendation to buy or sell shares and does not take into account your goals or your financial situation. Our aim is to bring you long-term, targeted analysis based on fundamental data. Note that our analysis may not take into account the latest announcements from price sensitive companies or qualitative documents. Simply Wall St does not have any position in the mentioned stocks.
Do you have any feedback on this item? Are you worried about the content? Get in touch with us directly. You can also send an email to the editorial team (at) simplywallst.com.