One of the best investments we can make is in our knowledge and skills. With this in mind, this article will delve into how we can use Return on Equity (ROE) to better understand a business. We’ll use ROE to examine Heartshead Resources NL (ASX:HHR) through a worked example.
Return on equity or ROE is an important factor considered by a shareholder as it tells them how effectively their capital is being reinvested. In other words, it reflects the company’s success in converting shareholder investments into profits.
See our latest analysis for Heartshead Resources
How is ROE calculated?
Return on equity can be calculated using the formula:
Return on Equity = Net Profit (from continuing operations) ÷ Shareholders’ Equity
So, based on the above formula, the ROE for Heartshed Resources is:
4.3% = AU$1.5m ÷ AU$36m (based on trailing twelve months to June 2023).
‘Return’ is the income that the business earned in the last year. This means that for every A$1 worth of shareholders’ equity, the company made a profit of A$0.04.
Does Heartshead Resources have a good return on equity?
A simple way to determine whether a company has a good return on equity is to compare it to the average for its industry. Importantly, this is far from a perfect measurement, as companies vary considerably within the same industry classification. As shown in the graphic below, Heartshead Resources’ ROE is below average (18%) in the Oil & Gas industry classification.
This is definitely not ideal. However, a low ROE is not always bad. If the company’s debt level is moderate to low, there is still a possibility that returns can be improved through the use of financial leverage. A company with high debt having a low ROE is a different story altogether and a risky investment in our view. Visit our risks dashboard for free to learn about the 3 risks we have identified for Heartshed Resources.
Why You Should Consider Debt When Looking at ROE
Virtually all companies need money to invest in the business to increase profits. That cash can come from retained earnings, issuing new shares (equity), or debt. In the first and second cases, ROE will reflect this use of cash for investment in the business. In the latter case, the use of debt will improve returns, but will not change the equity. The ROE will look better than if no debt was used.
Heartshed Resources’ Debt and Its 4.3% ROE
Shareholders will be pleased to know that Heartshead Resources doesn’t have a single iota of net debt! Although I don’t think its ROE is that good, I think it’s pretty respectable when you consider it has no debt. After all, when a company has a strong balance sheet, it can often find ways to invest in growth, even if it takes some time.
Return on equity is a useful indicator of a business’s ability to generate profits and return them to shareholders. A company that can achieve high returns on equity without debt can be considered a high quality business. If two companies have the same ROE, I would generally prefer the company with less debt.
But ROE is just one piece of a larger puzzle, as high quality businesses often trade at high multiples of earnings. It is especially important to consider the profit growth rate, versus expectations reflected in the stock price. So you might want to check out this free visualization of analyst forecasts for the company.
But note: Heartshead Resources 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.
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This article from Simply Wall St is of a general nature. We only provide commentary based on historical data and analyst forecasts using unbiased methodology and our articles are not intended to provide financial advice. It does not recommend buying or selling any stock, and does not take into account your objectives, or your financial situation. Our goal is to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not take into account the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any of the stocks mentioned.