Should We Be Cautious About Construcciones y Auxiliar de Ferrocarriles, S.A.'s (BME:CAF) ROE Of 0.8%?

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.

ROE or return on equity is a useful tool to assess how effectively a company can generate returns on the investment it received from its shareholders. Simply put, it is used to assess the profitability of a company in relation to its equity capital.

See our latest analysis for Construcciones y Auxiliar de Ferrocarriles

How Is ROE Calculated?

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 Construcciones y Auxiliar de Ferrocarriles is:

0.8% = €5.1m ÷ €615m (Based on the trailing twelve months to September 2020).

The 'return' is the amount earned after tax over the last twelve months. Another way to think of that is that for every €1 worth of equity, the company was able to earn €0.01 in profit.

Does Construcciones y Auxiliar de Ferrocarriles Have A Good Return On Equity?

Arguably the easiest way to assess company's ROE is to compare it with the average in 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 lower ROE than the average (8.1%) in the Machinery industry classification.

Unfortunately, that's sub-optimal. However, a low ROE is not always bad. If the company's debt levels are moderate to low, then there's still a chance that returns can be improved via the use of financial leverage. When a company has low ROE but high debt levels, we would be cautious as the risk involved is too high. To know the 5 risks we have identified for Construcciones y Auxiliar de Ferrocarriles visit our risks dashboard for free.

Why You Should Consider Debt When Looking At ROE

Most companies need money -- from somewhere -- to grow their profits. The cash for investment can come from prior year profits (retained earnings), issuing new shares, or borrowing. In the case of the first and second options, the ROE will reflect this use of cash, for growth. 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.

Construcciones y Auxiliar de Ferrocarriles' Debt And Its 0.8% ROE

Construcciones y Auxiliar de Ferrocarriles clearly uses a high amount of debt to boost returns, as it has a debt to equity ratio of 1.96. 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. 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 ROE is just one piece of a bigger puzzle, since high quality businesses often trade on high multiples of earnings. 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 check this FREE visualization of analyst forecasts for the company.

Of course, you might find a fantastic investment by looking elsewhere. So take a peek at this free list of interesting companies.

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