Many investors are still learning the different metrics that can be useful when analyzing a stock. This article is for those who want to know more about return on equity (ROE). Learning by doing, we will look at ROE to better understand Bufab AB (publ) (STO: BUFAB).
Return on equity or ROE is a key metric used to gauge how effectively a company’s management is using the company’s capital. In simpler terms, it measures a company’s profitability relative to equity.
Our analysis indicates that BUFAB is potentially undervalued!
How do you calculate return on equity?
Return on equity can be calculated using the formula:
Return on equity = Net income (from continuing operations) ÷ Equity
So, based on the above formula, the ROE for Bufab is:
21% = 589 million kr ÷ 2.9 billion kr (based on the last twelve months to September 2022).
“Yield” is the income the business has earned over the past year. This therefore means that for each investment of 1 SEK by its shareholder, the company generates a profit of 0.21 SEK.
Does Bufab have a good return on equity?
Perhaps the easiest way to assess a company’s ROE is to compare it to the industry average. However, this method is only useful as a rough check, as companies differ quite a bit within the same industry classification. If you look at the image below, you can see that Bufab has a similar ROE to the average of the Commercial Distributor Industry ranking (24%).
It’s neither particularly good nor bad. Although at least the ROE is not lower than the industry, it is always worth checking the role that the company’s debt plays, since high levels of debt relative to equity can also give the impression that the ROE is high. If so, this increases its exposure to financial risk.
The Importance of Debt to Return on Equity
Virtually all businesses need money to invest in the business, 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 case of the first and second options, the ROE will reflect this use of cash, for growth. In the latter case, debt used for growth will enhance returns, but will not affect total equity. In this way, the use of debt will increase ROE, even though the core economics of the business remains the same.
Bufab’s debt and its ROE of 21%
Of note is Bufab’s heavy use of debt, leading to its debt-to-equity ratio of 1.27. There is no doubt that ROE is impressive, but it is worth bearing in mind that the measure could have been lower if the company had reduced its debt. Debt brings additional risk, so it’s only really worth it when a business is generating decent returns.
Return on equity is a useful indicator of a company’s ability to generate profits and return them to shareholders. Companies that can earn high returns on equity without too much debt are generally of good quality. If two companies have roughly the same level of debt and one has a higher ROE, I generally prefer the one with a higher ROE.
But ROE is only one piece of a larger puzzle, as high-quality companies often trade on high earnings multiples. The rate at which earnings are likely to grow, relative to earnings growth expectations reflected in the current price, should also be considered. So you might want to check this out for FREE visualization of analyst forecasts for the business.
Sure, you might find a fantastic investment by looking elsewhere. So take a look at this free list of interesting companies.
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This Simply Wall St article is general in nature. We provide commentary based on historical data and analyst forecasts only using unbiased methodology and our articles are not intended to be financial advice. It is not a recommendation to buy or sell stocks and does not take into account your objectives or financial situation. Our goal is to bring you targeted long-term analysis based on fundamental data. Note that our analysis may not take into account the latest announcements from price-sensitive companies or qualitative materials. Simply Wall St has no position in the stocks mentioned.