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. We'll use ROE to examine Singapore Technologies Engineering Ltd (SGX:S63), by way of a worked example.
ROE or return on equity is a useful tool to assess how effectively a company can generate returns on the investment it received from its shareholders. In short, ROE shows the profit each dollar generates with respect to its shareholder investments.
How Is ROE Calculated?
ROE can be calculated by using the formula:
Return on Equity = Net Profit (from continuing operations) ÷ Shareholders' Equity
So, based on the above formula, the ROE for Singapore Technologies Engineering is:
22% = S$604m ÷ S$2.8b (Based on the trailing twelve months to December 2023).
The 'return' is the amount earned after tax over the last twelve months. One way to conceptualize this is that for each SGD1 of shareholders' capital it has, the company made SGD0.22 in profit.
Does Singapore Technologies Engineering Have A Good ROE?
By comparing a company's ROE with its industry average, we can get a quick measure of how good it is. 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, Singapore Technologies Engineering has a better ROE than the average (7.8%) in the Aerospace & Defense industry.
That is a good sign. With that said, a high ROE doesn't always indicate high profitability. Aside from changes in net income, a high ROE can also be the outcome of high debt relative to equity, which indicates risk. You can see the 2 risks we have identified for Singapore Technologies Engineering by visiting our risks dashboard for free on our platform here.
Why You Should Consider Debt When Looking At ROE
Virtually all companies need money to invest in the business, to grow 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 debt used for growth will improve returns, but won't affect the total equity. In this manner the use of debt will boost ROE, even though the core economics of the business stay the same.
Combining Singapore Technologies Engineering's Debt And Its 22% Return On Equity
It's worth noting the high use of debt by Singapore Technologies Engineering, leading to its debt to equity ratio of 2.22. While its ROE is pretty respectable, the amount of debt the company is carrying currently is not ideal. Debt does bring extra risk, so it's only really worthwhile when a company generates some decent returns from it.
Summary
Return on equity is a useful indicator of the ability of a business to generate profits and return them to shareholders. Companies that can achieve high returns on equity without too much debt are generally of good quality. All else being equal, a higher ROE is better.
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. So you might want to check this FREE visualization of analyst forecasts for the company.
Of course Singapore Technologies Engineering 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.
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This article by Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any stocks mentioned.