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 Saudi Kayan Petrochemical Company (TADAWUL:2350), by way of a worked example.
Return on Equity or ROE is a test of how effectively a company is growing its value and managing investors’ money. In other words, it is a profitability ratio which measures the rate of return on the capital provided by the company's shareholders.
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 Kayan Petrochemical is:
1.5% = ر.س225m ÷ ر.س15b (Based on the trailing twelve months to March 2021).
The 'return' is the income the business earned over the last year. Another way to think of that is that for every SAR1 worth of equity, the company was able to earn SAR0.02 in profit.
Does Saudi Kayan Petrochemical Have A Good ROE?
By comparing a company's ROE with its industry average, we can get a quick measure of how good it is. 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 Kayan Petrochemical has a lower ROE than the average (6.8%) in the Chemicals 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. A company with high debt levels and low ROE is a combination we like to avoid given the risk involved.
How Does Debt Impact Return On Equity?
Most companies need money -- from somewhere -- to grow their profits. That cash can come from retained earnings, issuing new shares (equity), or debt. In the case of the first and second options, the ROE will reflect this use of cash, for growth. In the latter case, the debt used for growth will improve returns, but won't affect the total equity. In this manner the use of debt will boost ROE, even though the core economics of the business stay the same.
Combining Saudi Kayan Petrochemical's Debt And Its 1.5% Return On Equity
Saudi Kayan Petrochemical clearly uses a high amount of debt to boost returns, as it has a debt to equity ratio of 1.13. The combination of a rather low ROE and significant use of debt is not particularly appealing. 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 a useful indicator of the ability of a business to generate profits and return them to shareholders. In our books, the highest quality companies have high return on equity, despite low debt. All else being equal, a higher ROE is better.
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 take a peek at this data-rich interactive graph of forecasts for the company.
But note: Saudi Kayan Petrochemical may not be the best stock to buy. So take a peek at this free list of interesting companies with high ROE and low debt.
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