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 SAKAI Holdings CO.,LTD (TYO:9446), by way of a worked example.
Return on equity or ROE is a key measure used to assess how efficiently a company's management is utilizing the company's capital. In simpler terms, it measures the profitability of a company in relation to shareholder's equity.
Check out our latest analysis for SAKAI HoldingsLTD
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 SAKAI HoldingsLTD is:
24% = JP¥904m ÷ JP¥3.8b (Based on the trailing twelve months to December 2020).
The 'return' is the amount earned after tax over the last twelve months. One way to conceptualize this is that for each ¥1 of shareholders' capital it has, the company made ¥0.24 in profit.
Does SAKAI HoldingsLTD 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. However, this method is only useful as a rough check, because companies do differ quite a bit within the same industry classification. As you can see in the graphic below, SAKAI HoldingsLTD has a higher ROE than the average (8.9%) in the Specialty Retail industry.
That is a good sign. However, bear in mind that a high ROE doesn’t necessarily indicate efficient profit generation. Aside from changes in net income, a high ROE can also be the outcome of high debt relative to equity, which indicates risk. Our risks dashboardshould have the 3 risks we have identified for SAKAI HoldingsLTD.
The Importance Of Debt To Return On Equity
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 first and second cases, the ROE will reflect this use of cash for investment in the business. In the latter case, the debt required for growth will boost returns, but will not impact the shareholders' equity. Thus the use of debt can improve ROE, albeit along with extra risk in the case of stormy weather, metaphorically speaking.
SAKAI HoldingsLTD's Debt And Its 24% ROE
We think SAKAI HoldingsLTD uses a significant amount of debt to maximize its returns, as it has a significantly higher debt to equity ratio of 5.61. Its ROE is clearly quite good, but it seems to be boosted by the significant use of debt by the company.
Conclusion
Return on equity is useful for comparing the quality of different businesses. In our books, the highest quality companies have high return on equity, despite low debt. All else being equal, a higher ROE is better.
Having said that, while ROE is a useful indicator of business quality, you'll have to look at a whole range of factors to determine the right price to buy a stock. It is important to consider other factors, such as future profit growth -- and how much investment is required going forward. So I think it may be worth checking this free this detailed graph of past earnings, revenue and cash flow.
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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This article by Simply Wall St is general in nature. 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.
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About TSE:9446
Established dividend payer and good value.
