One of the best investments we can make is friedman be od deluxein our own knowledge and skill set. With that in mind, this article will work through how we can use Return On Equity (ROE) to better understand a business. We’ll use ROE to examine Triad Group plc (

LON:TRD

), by way of a worked example.

Our data shows

Triad Group has a return on equity of 25%

for the last year. Another way to think of that is that for every £1 worth of equity in the company, it was able to earn £0.25.

See our latest analysis for Triad Group

How Do You Calculate ROE?

The

formula for ROE

is:

Return on Equity = Net Profit ÷ Shareholders’ Equity

Or for Triad Group:

25% = 1.348 ÷ UK£5.5m (Based on the trailing twelve months to September 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 Signify?

ROE measures a company’s profitability against the profit it retains, and any outside investments. The ‘return’ is the yearly profit. A higher profit will lead to a higher ROE. So, all else equal,

investors should like a high ROE

. That means ROE can be used to compare two businesses.

Does Triad 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. Importantly, this is far from a perfect measure, because companies differ significantly within the same industry classification. Pleasingly, Triad Group has a superior ROE than the average (11%) company in the IT industry.

LSE:TRD Last Perf January 2nd 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

.

How Does Debt Impact Return On Equity?

Most companies need money — from somewhere — to grow their profits. That cash can come from issuing shares, retained earnings, or debt. In the first and second cases, the ROE will reflect this use of cash for investment in the business. 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 Triad Group’s Debt And Its 25% Return On Equity

While Triad Group does have a tiny amount of debt, with debt to equity of just 0.0038, we think the use of debt is very modest. When I see a high ROE, fuelled by only modest debt, I suspect 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.

Story continues

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. In my book the highest quality companies have high return on equity, despite low debt. 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. You can see how the company has grow in the past by looking at this FREE

detailed graph

of past earnings, revenue and cash flow

.

If you would prefer check out another company — one with potentially superior financials — then do not miss this

free

list of interesting companies, that have HIGH return on equity 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

[email protected]

.

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