Is Construcciones y Auxiliar de Ferrocarriles, S.A.'s (BME:CAF) 7.2% ROE Better Than Average?

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. We'll use ROE to examine Construcciones y Auxiliar de Ferrocarriles, S.A. (BME:CAF), 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 other words, it is a profitability ratio which measures the rate of return on the capital provided by the company's shareholders.

Check out our latest analysis for Construcciones y Auxiliar de Ferrocarriles

How To Calculate Return On Equity?

ROE can be calculated by using the formula:

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

So, based on the above formula, the ROE for Construcciones y Auxiliar de Ferrocarriles is:

7.2% = €59m ÷ €818m (Based on the trailing twelve months to June 2023).

The 'return' is the yearly profit. So, this means that for every €1 of its shareholder's investments, the company generates a profit of €0.07.

Does Construcciones y Auxiliar de Ferrocarriles 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. The limitation of this approach is that some companies are quite different from others, even within the same industry classification. If you look at the image below, you can see Construcciones y Auxiliar de Ferrocarriles has a similar ROE to the average in the Machinery industry classification (8.2%).

So while the ROE is not exceptional, at least its acceptable. While at least the ROE is not lower than the industry, its still worth checking what role the company's debt plays as high debt levels relative to equity may also make the ROE appear high. If so, this increases its exposure to financial risk. Our risks dashboardshould have the 2 risks we have identified for Construcciones y Auxiliar de Ferrocarriles.

How Does Debt Impact ROE?

Most companies need money -- from somewhere -- to grow their profits. That cash can come from retained earnings, issuing new shares (equity), 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 won't affect the total equity. In this manner the use of debt will boost ROE, even though the core economics of the business stay the same.

Combining Construcciones y Auxiliar de Ferrocarriles' Debt And Its 7.2% Return On Equity

It's worth noting the high use of debt by Construcciones y Auxiliar de Ferrocarriles, leading to its debt to equity ratio of 1.05. Its ROE is quite low, even with the use of significant debt; that's not a good result, in our opinion. 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.

Conclusion

Return on equity is a useful indicator of the ability of a business to generate profits and return them to shareholders. 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. It is important to consider other factors, such as future profit growth -- and how much investment is required going forward. So you might want to take a peek at this data-rich interactive graph of forecasts for the company.

Of course Construcciones y Auxiliar de Ferrocarriles 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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This article by Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any stocks mentioned.