One of the best investments we can make is in our own knowledge and skill set. With that in mind, this article will work through how we can use Return On Equity (ROE) to better understand a business. We'll use ROE to examine TAG Immobilien AG (ETR:TEG), by way of a worked example.
Return on Equity or ROE is a test of how effectively a company is growing its value and managing investors’ money. In simpler terms, it measures the profitability of a company in relation to shareholder's equity.
See our latest analysis for TAG Immobilien
How Do You Calculate Return On Equity?
The formula for return on equity is:
Return on Equity = Net Profit (from continuing operations) ÷ Shareholders' Equity
So, based on the above formula, the ROE for TAG Immobilien is:
15% = €378m ÷ €2.5b (Based on the trailing twelve months to September 2020).
The 'return' is the yearly profit. Another way to think of that is that for every €1 worth of equity, the company was able to earn €0.15 in profit.
Does TAG Immobilien Have A Good ROE?
By comparing a company's ROE with its industry average, we can get a quick measure of how good it is. However, this method is only useful as a rough check, because companies do differ quite a bit within the same industry classification. As is clear from the image below, TAG Immobilien has a better ROE than the average (9.5%) in the Real Estate industry.
That is a good sign. With that said, a high ROE doesn't always indicate high profitability. A higher proportion of debt in a company's capital structure may also result in a high ROE, where the high debt levels could be a huge risk . Our risks dashboardshould have the 4 risks we have identified for TAG Immobilien.
The Importance Of Debt To Return On Equity
Companies usually need to invest money to grow their profits. The cash for investment can come from prior year profits (retained earnings), issuing new shares, or 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 the returns, but will not change the equity. Thus the use of debt can improve ROE, albeit along with extra risk in the case of stormy weather, metaphorically speaking.
TAG Immobilien's Debt And Its 15% ROE
TAG Immobilien does use a high amount of debt to increase returns. It has a debt to equity ratio of 1.28. There's no doubt its ROE is decent, but the very high debt the company carries is not too exciting to see. Investors should think carefully about how a company might perform if it was unable to borrow so easily, because credit markets do change over time.
Summary
Return on equity is one way we can compare its business quality of different companies. In our books, the highest quality companies have high return on equity, despite low debt. All else being equal, a higher ROE is better.
But when a business is high quality, the market often bids it up to a price that reflects this. Profit growth rates, versus the expectations reflected in the price of the stock, are a particularly important to consider. So you might want to check this FREE visualization of analyst forecasts for the company.
Of course TAG Immobilien may not be the best stock to buy. So you may wish to see this free collection of other companies that have high ROE and low debt.
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About XTRA:TEG
TAG Immobilien
A real estate company, engages in the acquisition, development, and management of residential real estate properties in Germany.
Moderate growth potential and slightly overvalued.