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. To keep the lesson grounded in practicality, we'll use ROE to better understand Altri, SGPS, S.A. (ELI:ALTR).
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.
How Do You Calculate Return On Equity?
The formula for ROE is:
Return on Equity = Net Profit (from continuing operations) ÷ Shareholders' Equity
So, based on the above formula, the ROE for Altri SGPS is:
15% = €70m ÷ €468m (Based on the trailing twelve months to June 2021).
The 'return' is the yearly profit. That means that for every €1 worth of shareholders' equity, the company generated €0.15 in profit.
Does Altri SGPS 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. As is clear from the image below, Altri SGPS has a better ROE than the average (11%) in the Forestry industry.
That is a good sign. With that said, a high ROE doesn't always indicate high profitability. Especially when a firm uses high levels of debt to finance its debt which may boost its ROE but the high leverage puts the company at risk. You can see the 3 risks we have identified for Altri SGPS by visiting our risks dashboard for free on our platform here.
The Importance Of Debt To Return On Equity
Virtually all companies need money to invest in the business, to grow 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 debt used for growth will improve returns, but won't affect the total equity. That will make the ROE look better than if no debt was used.
Combining Altri SGPS' Debt And Its 15% Return On Equity
Altri SGPS clearly uses a high amount of debt to boost returns, as it has a debt to equity ratio of 1.98. There's no doubt its ROE is decent, but the very high debt the company carries is not too exciting to see. Debt increases risk and reduces options for the company in the future, so you generally want to see some good returns from using it.
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. 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.
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.
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