Many investors are still learning about the various metrics that can be useful when analysing a stock. This vacation house rules inn on the marketarticle is for those who would like to learn about Return On Equity (ROE). We'll use ROE to examine IAR Systems Group AB (publ) (

STO:IAR B

), by way of a worked example.

IAR Systems Group has a ROE of 14%

, based on the last twelve months. Another way to think of that is that for every SEK1 worth of equity in the company, it was able to earn SEK0.14.

View our latest analysis for IAR Systems Group

How Do I Calculate ROE?

The

formula for return on equity

is:

Return on Equity = Net Profit (from continuing operations) ÷ Shareholders' Equity

Or for IAR Systems Group:

14% = kr83m ÷ kr574m (Based on the trailing twelve months to September 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 the capital paid in by shareholders, plus any retained earnings. You can calculate shareholders' equity by subtracting the company's total liabilities from its total assets.

What Does Return On Equity Mean?

Return on Equity measures a company's profitability against the profit it has kept for the business (plus any capital injections). The 'return' is the amount earned after tax over the last twelve months. A higher profit will lead to a higher ROE. So, all else equal,

investors should like a high ROE

. That means it can be interesting to compare the ROE of different companies.

Does IAR Systems Group Have A Good Return On Equity?

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. The image below shows that IAR Systems Group has an ROE that is roughly in line with the Software industry average (14%).

OM:IAR B Past Revenue and Net Income, January 1st 2020

That's not overly surprising. ROE can give us a view about company quality, but many investors also look to other factors, such as whether there are insiders buying shares. If you are like me, then you will

not

want to miss this

free

list of growing companies that insiders are buying.

Why You Should Consider Debt When Looking At ROE

Most companies need money -- from somewhere -- to grow their profits. That cash can come from issuing shares, retained earnings, 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. Thus the use of debt can improve ROE, albeit along with extra risk in the case of stormy weather, metaphorically speaking.

Story continues

Combining IAR Systems Group's Debt And Its 14% Return On Equity

While IAR Systems Group does have a tiny amount of debt, with debt to equity of just 0.043, we think the use of debt is very modest. The combination of modest debt and a very respectable ROE suggests this is a business worth watching. 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.

The Bottom Line On ROE

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 around the same level of debt to equity, and one has a higher ROE, I'd generally prefer the one with higher ROE.

But ROE is just one piece of a bigger puzzle, since high quality businesses often trade on high multiples of earnings. It is important to consider other factors, such as future profit growth -- and how much investment is required going forward. So I think it may be worth checking this

free

report on analyst forecasts for the company

.

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.

If you spot an error that warrants correction, please contact the editor at

[email protected]

. 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.

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