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 Saudi Chemical Holding Company (TADAWUL:2230).
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 Saudi Chemical Holding is:
4.6% = ر.س78m ÷ ر.س1.7b (Based on the trailing twelve months to March 2021).
The 'return' refers to a company's earnings over the last year. That means that for every SAR1 worth of shareholders' equity, the company generated SAR0.05 in profit.
Does Saudi Chemical Holding 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. If you look at the image below, you can see Saudi Chemical Holding has a lower ROE than the average (7.8%) in the Healthcare industry classification.
Unfortunately, that's sub-optimal. That being said, a low ROE is not always a bad thing, especially if the company has low leverage as this still leaves room for improvement if the company were to take on more debt. When a company has low ROE but high debt levels, we would be cautious as the risk involved is too high. You can see the 2 risks we have identified for Saudi Chemical Holding 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. 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. That will make the ROE look better than if no debt was used.
Saudi Chemical Holding's Debt And Its 4.6% ROE
Saudi Chemical Holding does use a high amount of debt to increase returns. It has a debt to equity ratio of 1.19. With a fairly low ROE, and significant use of debt, it's hard to get excited about this business at the moment. 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.
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. 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. It is important to consider other factors, such as future profit growth -- and how much investment is required going forward. Check the past profit growth by Saudi Chemical Holding by looking at this visualization 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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