One of the best investments we can make is in 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. We'll use ROE to examine Quad/Graphics, Inc. (NYSE:QUAD), by way of a worked example.

Return on Equity or ROE is a test of how effectively a company is growing its value and managing investors’ money. Simply put, it is used to assess the profitability of a company in relation to its equity capital.

View our latest analysis for Quad/Graphics

The formula for return on equity is:

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

So, based on the above formula, the ROE for Quad/Graphics is:

19% = US$27m ÷ US$137m (Based on the trailing twelve months to March 2022).

The 'return' is the income the business earned over the last year. That means that for every $1 worth of shareholders' equity, the company generated $0.19 in profit.

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, Quad/Graphics has a better ROE than the average (10%) in the Commercial Services industry.

That's clearly a positive. However, bear in mind that a high ROE doesn’t necessarily indicate efficient profit generation. Aside from changes in net income, a high ROE can also be the outcome of high debt relative to equity, which indicates risk. Our risks dashboardshould have the 2 risks we have identified for Quad/Graphics.

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 and second cases, the ROE will reflect this use of cash for investment in the business. 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.

It seems that Quad/Graphics uses a huge volume of debt to fund the business, since it has an extremely high debt to equity ratio of 5.82. Its ROE is respectable, but it's not so impressive once you consider all of the debt.

Return on equity is a useful indicator of the ability of a business to generate profits and return them to shareholders. 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.

But ROE is just one piece of a bigger puzzle, since high quality businesses often trade on high multiples of earnings. Profit growth rates, versus the expectations reflected in the price of the stock, are a particularly important to consider. Check the past profit growth by Quad/Graphics by looking at this visualization of past earnings, revenue and cash flow.

Of course, you might find a fantastic investment by looking elsewhere. So take a peek at this free list of interesting companies.

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