While some investors are already familiar with financial metrics (hat trick), this article is for those who want to learn more about return on equity (ROE) and why it matters. To keep the lesson grounded in practicality, we’ll use ROE to better understand Schaltbau Holding AG (ETR: SLT).
ROE or return on equity is a useful tool for evaluating how effectively a company can generate returns on the investment it has received from its shareholders. In short, ROE shows the profit that each dollar generates in relation to the investments of its shareholders.
How to calculate return on equity?
the return on equity formula is:
Return on equity = Net income (from continuing operations) ÷ Equity
So, based on the above formula, the ROE of Schaltbau Holding is:
9.0% = €8.7m ÷ €96m (based on the last twelve months to September 2020).
The “yield” is the amount earned after tax over the last twelve months. This therefore means that for each €1 of investment by its shareholder, the company generates a profit of €0.09.
Does Schaltbau Holding have a good return on equity?
By comparing a company’s ROE with the average for its industry, we can get a quick measure of its quality. However, this method is only useful as a rough check, as companies differ quite a bit within the same industry classification. Fortunately, Schaltbau Holding has an above-average ROE (5.6%) for the machinery industry.
This is clearly a positive point. Keep in mind that a high ROE does not always mean superior financial performance. Especially when a company uses high levels of debt to finance its debt, which can increase its ROE, but the high leverage puts the company at risk. To find out about the 2 risks we have identified for Schaltbau Holding visit our risk dashboard for free.
The Importance of Debt to Return on Equity
Most businesses need money – from somewhere – to increase their profits. The money for the investment can come from the previous year’s earnings (retained earnings), from issuing new shares or from borrowing. 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 returns, but will not change equity. Thus, the use of debt can improve ROE, but with an additional risk in the event of a storm, metaphorically speaking.
Combination of Schaltbau Holding’s debt and its return on equity of 9.0%
Schaltbau Holding is clearly using a high amount of debt to boost returns, as its debt-to-equity ratio is 1.15. The combination of a rather low ROE and heavy reliance on debt is not particularly attractive. Debt brings additional risk, so it’s only really worth it when a business is generating decent returns.
Return on equity is useful for comparing the quality of different companies. Companies that can earn high returns on equity without too much debt are generally of good quality. All things being equal, a higher ROE is better.
That said, while ROE is a useful indicator of a company’s quality, you’ll need to consider a whole host of factors to determine the right price to buy a stock. It is important to consider other factors, such as future earnings growth and the amount of investment needed in the future. So you might want to check this out for FREE visualization of analyst forecasts for the business.
If you’d rather check out another company – one with potentially superior finances – then don’t miss this free list of attractive companies, which have a high return on equity and low debt.
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