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. To keep the lesson grounded in practicality, well use ROE to better understand Avecho Biotechnology Limited (ASX:AVE).
Over the last twelve months Avecho Biotechnology has recorded a ROE of 2.5%. One way to conceptualize this, is that for each A$1 of shareholders equity it has, the company made A$0.03 in profit.
Check out our latest analysis for Avecho Biotechnology
The formula for ROE is:
Return on Equity = Net Profit (from continuing operations) Shareholders Equity
Or for Avecho Biotechnology:
2.5% = AU$158k AU$6.2m (Based on the trailing twelve months to June 2019.)
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 companys total liabilities from the total assets.
Return on Equity measures a companys 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 ROE can be used to compare two businesses.
One simple way to determine if a company has a good return on equity is to compare it to the average for its industry. However, this method is only useful as a rough check, because companies do differ quite a bit within the same industry classification. As is clear from the image below, Avecho Biotechnology has a lower ROE than the average (7.7%) in the Pharmaceuticals industry.
That certainly isnt ideal. Wed prefer see an ROE above the industry average, but it might not matter if the company is undervalued. Nonetheless, it might be wise to check if insiders have been selling.
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 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.
Avecho Biotechnology is free of net debt, which is a positive for shareholders. Without a doubt it has a fairly low ROE, but that isnt so bad when you consider it has no debt. At the end of the day, when a company has zero debt, it is in a better position to take future growth opportunities.
Return on equity is useful for comparing the quality of different businesses. A company that can achieve a high return on equity without debt could be considered a high quality business. If two companies have the same ROE, then I would generally prefer the one with less debt.
But when a business is high quality, the market often bids it up to a price that reflects this. It is important to consider other factors, such as future profit growth and how much investment is required going forward. Check the past profit growth by Avecho Biotechnology 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.
If you spot an error that warrants correction, please contact the editor at editorial-team@simplywallst.com. 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.
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. Thank you for reading.
Link:
Read This Before Judging Avecho Biotechnology Limiteds (ASX:AVE) ROE - Simply Wall St
Recommendation and review posted by G. Smith
