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 Fodelia Oyj (HEL:FODELIA).
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. In simpler terms, it measures the profitability of a company in relation to shareholder's equity.
How To 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 Fodelia Oyj is:
7.1% = €623k ÷ €8.8m (Based on the trailing twelve months to December 2020).
The 'return' is the income the business earned over the last year. That means that for every €1 worth of shareholders' equity, the company generated €0.07 in profit.
Does Fodelia Oyj Have A Good ROE?
Arguably the easiest way to assess company's ROE is to compare it with the average in its industry. However, this method is only useful as a rough check, because companies do differ quite a bit within the same industry classification. The image below shows that Fodelia Oyj has an ROE that is roughly in line with the Food industry average (7.7%).
That's neither particularly good, nor bad. Although the ROE is similar to the industry, we should still perform further checks to see if the company's ROE is being boosted by high debt levels. If so, this increases its exposure to financial risk. Our risks dashboardshould have the 4 risks we have identified for Fodelia Oyj.
Why You Should Consider Debt When Looking At ROE
Companies usually need to invest money to grow their profits. That cash can come from issuing shares, retained earnings, or debt. 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.
Combining Fodelia Oyj's Debt And Its 7.1% Return On Equity
While Fodelia Oyj does have some debt, with a debt to equity ratio of just 0.92, we wouldn't say debt is excessive. I'm not impressed with its ROE, but the debt levels are not too high, indicating the business has decent prospects. Careful use of debt to boost returns is often very good for shareholders. However, it could reduce the company's ability to take advantage of future opportunities.
Return on equity is useful for comparing the quality of different businesses. Companies that can achieve high returns on equity without too much debt are generally of good quality. 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 I think it may be worth checking this free report on analyst forecasts for the company.
Of course Fodelia Oyj 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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