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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). To keep the lesson grounded in practicality, we’ll use ROE to better understand NNIT A/S (
CPH:NNIT
).
Our data shows
NNIT has a return on equity of 22%
for the last year. Another way to think of that is that for every DKK1 worth of equity in the company, it was able to earn DKK0.22.
Check out our latest analysis for NNIT
How Do You Calculate ROE?
The
formula for ROE
is:
Return on Equity = Net Profit ÷ Shareholders’ Equity
Or for NNIT:
22% = 235.606 ÷ ø1.1b (Based on the trailing twelve months to December 2018.)
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 earnings retained by the company, plus any capital paid in by shareholders. The easiest way to calculate shareholders’ equity is to subtract the company’s total liabilities from the total assets.
What Does Return On Equity Mean?
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. A higher profit will lead to a higher ROE. So, all else being equal,
a high ROE is better than a low one
. That means it can be interesting to compare the ROE of different companies.
Does NNIT Have A Good Return On Equity?
By comparing a company’s ROE with its industry average, we can get a quick measure of how good it is. 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, NNIT has a better ROE than the average (13%) in the Healthcare Services industry.
CPSE:NNIT Last Perf February 1st 19
That is a good sign. In my book, a high ROE almost always warrants a closer look. One data point to check is if
insiders have bought shares recently
.
Why You Should Consider Debt When Looking At ROE
Most companies need money — from somewhere — to grow their profits. That cash can come from retained earnings, issuing new shares (equity), or debt. 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. That will make the ROE look better than if no debt was used.
Story continues
Combining NNIT’s Debt And Its 22% Return On Equity
While NNIT does have some debt, with debt to equity of just 0.58, we wouldn’t say debt is excessive. When I see a high ROE, fuelled by only modest debt, I suspect the business is high quality. Judicious use of debt to improve returns can certainly be a good thing, although it does elevate risk slightly and reduce future optionality.
The Bottom Line On ROE
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. 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.
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
.
Of course
NNIT may not be the best stock to buy
. So you may wish to see this
free
collection of other companies that have 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
.
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