One of the best investments we can make is what does a bee symbolize in the biblein 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. To keep the lesson grounded in practicality, we’ll use ROE to better understand Science Applications International Corporation (

NYSE:SAIC

).

Our data shows

Science Applications International has a return on equity of 48%

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 $0.48.

View our latest analysis for Science Applications International

How Do I Calculate Return On Equity?

The

formula for return on equity

is:

Return on Equity = Net Profit ÷ Shareholders’ Equity

Or for Science Applications International:

48% = 197 ÷ US$411m (Based on the trailing twelve months to November 2018.)

Most readers would understand what net profit is, but it’s worth explaining the concept of shareholders’ equity. 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 ROE Mean?

ROE looks at the amount a company earns relative to the money it has kept within the business. The ‘return’ is the yearly profit. A higher profit will lead to a higher ROE. So, as a general rule,

a high ROE is a good thing

. Clearly, then, one can use ROE to compare different companies.

Does Science Applications International Have A Good ROE?

Arguably the easiest way to assess company’s ROE is to compare it with the average in its industry. The limitation of this approach is that some companies are quite different from others, even within the same industry classification. As is clear from the image below, Science Applications International has a better ROE than the average (15%) in the IT industry.

NYSE:SAIC Last Perf January 2nd 19

That’s clearly a positive. I usually take a closer look when a company has a better ROE than industry peers. For example,

I often check if insiders have been buying shares

.

How Does Debt Impact Return On Equity?

Virtually all companies need money to invest in the business, to grow 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. That will make the ROE look better than if no debt was used.

Combining Science Applications International’s Debt And Its 48% Return On Equity

It’s worth noting the significant use of debt by Science Applications International, leading to its debt to equity ratio of 2.52. There’s no doubt its ROE is impressive, but the company appears to use its debt to boost that metric. Debt increases risk and reduces options for the company in the future, so you generally want to see some good returns from using it.

Story continues

The Bottom Line On ROE

Return on equity is one way we can compare the business quality of different companies. A company that can achieve a high return on equity without debt could be considered a high quality business. 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.

Having said that, while ROE is a useful indicator of business quality, you’ll have to look at a whole range of factors to determine the right price to buy a stock. Profit growth rates, versus the expectations reflected in the price of the stock, are a particularly important to consider. So you might want to check this FREE

visualization of analyst forecasts for the company

.

Of course,

you might find a fantastic investment by looking elsewhere.

So take a peek at this

free

list of interesting companies.

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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