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 Perimeter Solutions, SA (NYSE:PRM).
Return on equity or ROE is an important factor for a shareholder to consider as it tells them how much of their capital is being reinvested. In other words, it reveals the company’s success in turning shareholders’ investments into profits.
Check out our latest analysis for Perimeter Solutions
How is ROE calculated?
Return on equity can be calculated using the formula:
Return on equity = Net income (from continuing operations) ÷ Equity
So, based on the formula above, the ROE for Perimeter Solutions is:
7.3% = $23 million ÷ $319 million (based on trailing twelve months to September 2021).
The “yield” is the amount earned after tax over the last twelve months. This therefore means that for every $1 of investment by its shareholder, the company generates a profit of $0.07.
Does Perimeter Solutions have a good ROE?
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. As the image below clearly shows, Perimeter Solutions has an ROE below the chemical industry average (14%).
Unfortunately, this is suboptimal. However, a low ROE is not always bad. If the company’s debt levels are moderate to low, there is always the possibility that returns could be enhanced through the use of leverage. When a company has a low ROE but a high level of debt, we would be cautious because the risk involved is too high.
What is the impact of debt on return on equity?
Most businesses need money – from somewhere – to increase their profits. This money 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, debt used for growth will enhance returns, but will not affect total equity. So using debt can improve ROE, but with the added risk of stormy weather, metaphorically speaking.
Combine Perimeter Solutions’ debt and its return on equity of 7.3%
Perimeter Solutions clearly uses a high amount of debt to increase returns, as its debt-to-equity ratio is 2.15. With a fairly low ROE and a significant reliance on debt, it is difficult to get enthusiastic about this activity at the moment. Investors need to think carefully about how a company would perform if it weren’t able to borrow so easily, as credit markets change over time.
Return on equity is a way to compare the business quality of different companies. In our books, the highest quality companies have a high return on equity, despite low leverage. 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.
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. Earnings growth rates, relative to expectations reflected in the share price, are particularly important to consider. So I think it’s worth checking it out free this detailed graph past profits, revenue and cash flow.
Sure Perimeter Solutions may not be the best stock to buy. So you might want to see this free collection of other companies that have high ROE and low debt.
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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.