Stock Analysis

Can Vulcan Steel Limited (ASX:VSL) Maintain Its Strong Returns?

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ASX:VSL
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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. To keep the lesson grounded in practicality, we'll use ROE to better understand Vulcan Steel Limited (ASX:VSL).

Return on equity or ROE is an important factor to be considered by a shareholder because it tells them how effectively their capital is being reinvested. In short, ROE shows the profit each dollar generates with respect to its shareholder investments.

Check out our latest analysis for Vulcan Steel

How Do You Calculate Return On Equity?

The formula for ROE is:

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

So, based on the above formula, the ROE for Vulcan Steel is:

71% = NZ$124m ÷ NZ$176m (Based on the trailing twelve months to December 2022).

The 'return' is the income the business earned over the last year. So, this means that for every A$1 of its shareholder's investments, the company generates a profit of A$0.71.

Does Vulcan Steel 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. Importantly, this is far from a perfect measure, because companies differ significantly within the same industry classification. As you can see in the graphic below, Vulcan Steel has a higher ROE than the average (17%) in the Metals and Mining industry.

roe
ASX:VSL Return on Equity March 15th 2023

That's clearly a positive. With that said, a high ROE doesn't always indicate high profitability. Aside from changes in net income, a high ROE can also be the outcome of high debt relative to equity, which indicates risk. You can see the 4 risks we have identified for Vulcan Steel by visiting our risks dashboard for free on our platform here.

The Importance Of Debt To Return On Equity

Most companies need money -- from somewhere -- to grow their profits. That cash can come from issuing shares, retained earnings, or debt. In the first and second cases, the ROE will reflect this use of cash for investment in the business. In the latter case, the use of debt will improve the returns, but will not change the equity. In this manner the use of debt will boost ROE, even though the core economics of the business stay the same.

Vulcan Steel's Debt And Its 71% ROE

It's worth noting the high use of debt by Vulcan Steel, leading to its debt to equity ratio of 2.22. There's no doubt the ROE is impressive, but it's worth keeping in mind that the metric could have been lower if the company were to reduce its debt. Debt does bring extra risk, so it's only really worthwhile when a company generates some decent returns from it.

Summary

Return on equity is a useful indicator of the ability of a business to generate profits and return them to shareholders. A company that can achieve a high return on equity without debt could be considered a high quality business. 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. The rate at which profits are likely to grow, relative to the expectations of profit growth reflected in the current price, must be considered, too. So you might want to take a peek at this data-rich interactive graph of forecasts for the company.

But note: Vulcan Steel may not be the best stock to buy. So take a peek at this free list of interesting companies with high ROE and low debt.

Valuation is complex, but we're helping make it simple.

Find out whether Vulcan Steel is potentially over or undervalued by checking out our comprehensive analysis, which includes fair value estimates, risks and warnings, dividends, insider transactions and financial health.

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