One of the best investments we can make is in our own knowledge and skills. With that in mind, this article will explain how we can use return on equity (ROE) to better understand a business. As part of a learning-by-doing, we will look at ROE to better understand Implenia AG (VTX:IMPN).
ROE or return on equity is a useful tool for evaluating how effectively a company can generate returns on the investment it has received from its shareholders. In other words, it is a profitability ratio that measures the rate of return on capital contributed by the company’s shareholders.
See our latest analysis for Implenia
How do you calculate return on equity?
ROE can be calculated using the formula:
Return on equity = Net income (from continuing operations) ÷ Equity
So, based on the above formula, the ROE for Implenia is:
18% = CHF 64 million ÷ CHF 346 million (based on the last twelve months until December 2021).
“Yield” is the income the business has earned over the past year. One way to conceptualize this is that for every CHF 1 of share capital it has, the company has made a profit of CHF 0.18.
Does Implenia have a good return on equity?
By comparing a company’s ROE with the average for its industry, we can get a quick measure of its quality. The limitation of this approach is that some companies are very different from others, even within the same industrial classification. As the image below clearly shows, Implenia has a better ROE than the construction industry average (11%).
It’s a good sign. Keep in mind that a high ROE does not always mean superior financial performance. Especially when a company uses high levels of debt to finance its debt, which can increase its ROE, but the high leverage puts the company at risk. To find out which 2 risks we have identified for Implenia, visit our risk dashboard for free.
Why You Should Consider Debt When Looking at ROE
Virtually all businesses need money to invest in the business, to increase their profits. This money 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, debt used for growth will enhance returns, but will not affect total equity. So using debt can improve ROE, but with the added risk of stormy weather, metaphorically speaking.
Combine Implenia’s debt and its return on equity of 18%
Implenia is clearly using a high amount of debt to increase returns, as its debt-to-equity ratio is 2.03. While its ROE is respectable, it’s worth bearing in mind that there’s usually a limit to the amount of debt a company can use. Debt brings additional risk, so it’s only really worth it when a business is generating decent returns.
Summary
Return on equity is useful for comparing the quality of different companies. In our books, the highest quality companies have a high return on equity, despite low leverage. If two companies have roughly the same level of debt and one has a higher ROE, I generally prefer the one with a higher ROE.
But when a company is of high quality, the market often gives it a price that reflects that. It is important to consider other factors, such as future earnings growth and the amount of investment needed in the future. You might want to check out this FREE analyst forecast visualization for the company.
But note: Implenia may not be the best stock to buy. So take a look at this free list of interesting companies with high ROE and low debt.
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This Simply Wall St article is general in nature. We provide commentary based on historical data and analyst forecasts only using unbiased methodology and our articles are not intended to be financial advice. It is not a recommendation to buy or sell stocks and does not take into account your objectives or financial situation. Our goal is to bring you targeted long-term analysis based on fundamental data. Note that our analysis may not take into account the latest announcements from price-sensitive companies or qualitative materials. Simply Wall St has no position in the stocks mentioned.