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One of the best investments we can make is in our own knowledge and skills. With this in mind, this article explains how we can use Return on Equity (ROE) to better understand a business.
We will use ROE to review Oil Search Limited (ASX: OSH) as a concrete example.
In the last twelve months Oil Search recorded an ROE of 6.6%.
This means that for every shareholders' equity, it generates a profit of 0.066 AUD.
Discover our latest badysis for oil research
How to calculate the return on equity?
the formula for ROE is:
Return on Equity = Net Earnings Equity Equity
Or for oil research:
6.6% = 341 million USD 5.2 billion USD (based on the twelve months preceding December 2018)
Most know that net profit is the total profit after all expenses, but the notion of own funds is a bit more complicated.
That's all the money paid to the corporation by the shareholders, plus the undistributed profits.
The simplest way to calculate equity is to subtract the total liabilities of the company from the total badets.
What does the return on equity mean?
ROE examines the amount that a company earns compared to the money that it has kept in the business.
The "return" is the profit of the last twelve months.
This means that the higher the ROE, the more profitable the company is.
So, as a rule, a high ROE is a good thing.
This means that it can be interesting to compare the ROE of different companies.
Does Oil Search have a good ROE?
By comparing a company's ROE to its industry average, we can get a quick measure of its quality.
However, this method is only useful as a rough check, as companies differ somewhat in the same industrial clbadification.
As shown in the graph below, the ROE of oil research is below the average (19%) of the oil and gas industry clbadification.
Unfortunately, this is not optimal.
We prefer it when the ROE of a company is above the industry average, but it is not the panacea if it is lower.
Nevertheless, it might be wise to check if insiders have sold.
Why should you consider a debt when you examine the ROE?
Almost all businesses need money to invest in the business and increase their profits.
The money for the investment can come from the profits of the previous fiscal year (retained earnings), the issuance of new shares or the loan.
In the first two cases, the OER will take into account this use of capital to grow.
In the latter case, the use of debt will improve returns, but will not change equity.
In this way, the use of debt will increase the ROE, even if the basic economy of the company remains the same.
The combination of Oil Search's debt and its return on equity of 6.6%
Oil Search has a debt / equity ratio of 0.66, which is far from excessive.
Its ROE is not particularly impressive, but the level of indebtedness is relatively modest and the company therefore has real potential.
The judicious use of debt to improve returns can certainly be a good thing, even if it slightly increases risk and reduces future opportunities.
In summary
Return on equity is a useful indicator of a company's ability to generate profits and return them to shareholders.
In my book, high quality companies have a high return on equity, despite low debt.
If two companies have roughly the same level of debt relative to share capital and one has a higher ROE, I would generally prefer the one with a higher ROE.
That said, while ROE is a useful indicator of the quality of the business, you will need to consider a variety of factors to determine the correct price for buying a security.
The probable rate of profit growth relative to the earnings growth forecast reflected in the current price must also be taken into account.
You may want to take a look at this interactive graph rich in forecast data for the company.
If you prefer to consult another company – a company with potentially higher finances – then do not miss this opportunity. free list of interesting companies, which have a high return on equity and a low debt.
Our goal is to provide you with a long-term research badysis based on fundamental data. Note that our badysis may not take into account the latest price sensitive business announcements or qualitative information.
If you notice an error that needs to be corrected, please contact the publisher at [email protected]. This article from Simply Wall St is of a general nature. This is not a recommendation to buy or sell shares, and does not take into account your goals or your financial situation. Simply Wall St has no position on the actions mentioned. Thanks for the reading.
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