1 day Ago By Simply Wall St.
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 RHI Magnesita N.V.
( ), by way of a worked example. Return on equity or ROE is an important factor to be considered by a shareholder because it tells them how effectively their capital is being reinvested. In short, ROE shows the profit each dollar generates with respect to its shareholder investments.
The is: Return on Equity = Net Profit (from continuing operations) ÷ Shareholders' Equity So, based on the above formula, the ROE for RHI Magnesita is: 14% = €199m ÷ €1.4b (Based on the trailing twelve months to June 2024). The 'return' is the profit over the last twelve months.
One way to conceptualize this is that for each £1 of shareholders' capital it has, the company made £0.14 in profit. By comparing a company's ROE with its industry average, we can get a quick measure of how good it is.
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, RHI Magnesita has a better ROE than the average (7.2%) in the .
That's what we like to see. However, bear in mind that a high ROE doesn’t necessarily indicate efficient profit generation. A higher proportion of debt in a company's capital structure may also result in a high ROE, where the high debt levels could be a huge risk .
You can see the 2 risks we have identified for RHI Magnesita by visiting our for free 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 two cases, the ROE will capture this use of capital to grow.
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. RHI Magnesita clearly uses a high amount of debt to boost returns, as it has a debt to equity ratio of 1.
29. While its ROE is respectable, it is worth keeping in mind that there is usually a limit as to how much debt a company can use. 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 a useful indicator of the ability of a business to generate profits and return them to shareholders. A company that can achieve a high return on equity without debt could be considered a high quality business. 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 .
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