Many investors are still educating themselves about the various metrics that can be useful when analyzing a stock. This article is for those who want to learn more about return on equity (ROE). To keep the lesson practical, we will use the ROE to better understand Arundel AG (VTX: ARON).
Return on equity or ROE is a key metric used to assess the efficiency with which the management of a business is using business capital. In other words, it is a profitability ratio that measures the rate of return on capital contributed by the shareholders of the company.
See our latest analysis for Arundel
How is the ROE calculated?
The formula for ROE is:
Return on equity = Net income (from continuing operations) ÷ Equity
So, based on the above formula, the ROE for Arundel is:
10% = US $ 3.3 million ÷ US $ 33 million (based on the last twelve months to June 2021).
The “return” is the amount earned after tax over the past twelve months. One way to conceptualize this is that for every CHF1 of share capital it has, the company has made a profit of CHF 0.10.
Does Arundel have a good ROE?
A simple way to determine if a company has a good return on equity is to compare it to the average in its industry. The limitation of this approach is that some companies are very different from others, even within the same industry classification. If you look at the image below, you can see that Arundel has an ROE similar to the real estate industry classification average (9.9%).
It is neither particularly good nor bad. Although the ROE is similar to that of the industry, we still need to perform additional checks to see if the company’s ROE is being boosted by high levels of debt. If so, it increases their exposure to financial risk. You can see the 4 risks we have identified for Arundel by visiting our risk dashboard for free on our platform here.
What is the impact of debt on ROE?
Almost all businesses need money to invest in the business, to increase their profits. This liquidity can come from the issuance of 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 will not affect total equity. This will make the ROE better than if no debt was used.
Combine Arundel’s debt and its 10% return on equity
It appears that Arundel is using a huge volume of debt to fund the business, as it has an extremely high debt ratio of 5.34. Its ROE is pretty good, but given the impact of debt, we’re less than excited overall.
Return on equity is useful for comparing the quality of different companies. Firms that can earn high returns on equity without taking on too much debt are generally of good quality. If two companies have the same ROE, then I would generally prefer the one with the least amount of debt.
But ROE is only one piece of a bigger puzzle, as high-quality companies often trade at high earnings multiples. Especially important to consider are the growth rates of earnings, relative to expectations reflected in the stock price. Check out Arundel’s past earnings growth by looking at this visualization of past earnings, income, and cash flow.
But beware : Arundel may not be the best stock to buy. So take a look at this free list of interesting companies with high ROE and low debt.
This Simply Wall St article is general in nature. We provide commentary based on historical data and analyst forecasts using only unbiased methodology and our articles are not intended to be financial advice. It does not constitute a recommendation to buy or sell shares and does not take into account your goals or your financial situation. Our aim is to bring you long-term, targeted analysis based on fundamental data. Note that our analysis may not take into account the latest announcements from price sensitive companies or qualitative material. Simply Wall St has no position in the mentioned stocks.
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