While some investors are already familiar with financial metrics (hat tip), this article is for those who want to learn more about return on equity (ROE) and why it’s important. As a learning by doing, we will look at the ROE to better understand InCity Immobilien AG (ETR: IC8).

Return on equity or ROE is a test of how effectively a company increases its value and manages investor money. In other words, it reveals the company’s success in turning shareholders’ investments into profits.

Consult our latest analysis for InCity Immobilien

How is the ROE calculated?

ROE can be calculated using the formula:

Return on equity = Net income (from continuing operations) ÷ Equity

Thus, based on the above formula, the ROE for InCity Immobilien is:

2.8% = 2.4 million euros ÷ 86 million euros (based on the last twelve months up to December 2020).

The “return” is the amount earned after tax over the past twelve months. One way to conceptualize this is that for every $ 1 in share capital it has, the company has made $ 0.03 in profit.

Does InCity Immobilien have a good ROE?

By comparing a company’s ROE with its industry average, we can get a quick measure of its quality. It is important to note that this measure is far from perfect, as companies differ considerably within a single industry classification. As shown in the graph below, InCity Immobilien has a lower than average ROE (8.0%) for the classification of the real estate industry.

XTRA: IC8 Return on equity June 9, 2021

This is not what we like to see. That being said, a low ROE isn’t always a bad thing, especially if the business has low leverage as it still leaves room for improvement if the business were to take on more debt. A heavily leveraged company with a low ROE is a whole different story and a risky investment on our books. To find out about the 2 risks that we have identified for InCity Immobilien, visit our risk dashboard free of charge.

Why You Should Consider Debt When Looking At ROE

Most businesses need money – from somewhere – to increase their profits. The money for the investment can come from the profits of the previous year (retained earnings), from the issuance of new shares or from loans. In the case of the first and second options, the ROE will reflect this use of cash, for growth. In the latter case, the use of debt will improve returns, but will not affect equity. So, using debt can improve ROE, but with added risk in stormy weather, metaphorically speaking.

Incity Immobilien’s debt and its ROE of 2.8%

InCity Immobilien clearly uses a high amount of debt to increase returns, as it has a leverage ratio of 1.05. With a fairly low ROE and heavy use of debt, it’s hard to get excited about this business right now. Investors should think carefully about how a business will perform if it weren’t able to borrow so easily, as credit markets change over time.

Conclusion

Return on equity is a useful indicator of a company’s ability to generate profits and return them to shareholders. Firms that can earn high returns on equity without taking on too much debt are generally of good quality. All other things being equal, a higher ROE is preferable.

But when a company is of high quality, the market often offers it up to a price that reflects that. It is important to take into account other factors, such as future profit growth and the amount of investment required for the future. So I think it’s worth checking this out free this detailed graphic past profits, income and cash flow.

If you would rather consult with another company – one with potentially superior finances – then don’t miss this free list of interesting companies, which have a HIGH return on equity and low leverage.

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This Simply Wall St article is general in nature. It does not constitute a recommendation to buy or sell shares and does not take into account your goals or your financial situation. Our aim is to bring you long-term, targeted analysis based on fundamental data. Note that our analysis may not take into account the latest announcements from price sensitive companies or qualitative material. Simply Wall St has no position in the mentioned stocks.
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