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Should You Be Excited About Paxman AB (publ)'s (STO:PAX) 9.7% Return On Equity?

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. By way of learning-by-doing, we'll look at ROE to gain a better understanding of Paxman AB (publ) (STO:PAX).

Paxman has a ROE of 9.7%, based on the last twelve months. That means that for every SEK1 worth of shareholders' equity, it generated SEK0.10 in profit.

Check out our latest analysis for Paxman

How Do I Calculate Return On Equity?

The formula for return on equity is:

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

Or for Paxman:

9.7% = kr2.8m ÷ kr28m (Based on the trailing twelve months to December 2019.)

It's easy to understand the 'net profit' part of that equation, but 'shareholders' equity' requires further explanation. It is the capital paid in by shareholders, plus any retained earnings. Shareholders' equity can be calculated by subtracting the total liabilities of the company from the total assets of the company.

What Does ROE Signify?

ROE looks at the amount a company earns relative to the money it has kept within the business. The 'return' is the profit over the last twelve months. The higher the ROE, the more profit the company is making. So, as a general rule, a high ROE is a good thing. That means it can be interesting to compare the ROE of different companies.

Does Paxman Have A Good ROE?

One simple way to determine if a company has a good return on equity is to compare it to the average for 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, Paxman has a better ROE than the average (7.0%) in the Medical Equipment industry.

OM:PAX Past Revenue and Net Income, February 24th 2020
OM:PAX Past Revenue and Net Income, February 24th 2020

That is a good sign. In my book, a high ROE almost always warrants a closer look. For example, I often check if insiders have been buying shares.

The Importance Of Debt To 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 case of the first and second options, the ROE will reflect this use of cash, for growth. In the latter case, the debt used for growth will improve returns, but won't affect the total equity. That will make the ROE look better than if no debt was used.

Combining Paxman's Debt And Its 9.7% Return On Equity

Paxman clearly uses a significant amount of debt to boost returns, as it has a debt to equity ratio of 1.11. There's no doubt the ROE is respectable, but it's worth keeping in mind that metric is elevated by the use of debt. Debt increases risk and reduces options for the company in the future, so you generally want to see some good returns from using it.

But It's Just One Metric

Return on equity is useful for comparing the quality of different businesses. Companies that can achieve high returns on equity without too much debt are generally of good quality. 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 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 I think it may be worth checking this free this detailed graph of past earnings, revenue and cash flow.

If you would prefer check out another company -- one with potentially superior financials -- then do not miss thisfree 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 editorial-team@simplywallst.com. 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.

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