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 Trajano Iberia Socimi, S.A. (BME:YTRA), by way of a worked example.
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.
See our latest analysis for Trajano Iberia Socimi
How To Calculate Return On Equity?
The formula for ROE is:
Return on Equity = Net Profit (from continuing operations) ÷ Shareholders’ Equity
So, based on the above formula, the ROE for Trajano Iberia Socimi is:
23% = €25m ÷ €106m (Based on the trailing twelve months to December 2019).
The ‘return’ refers to a company’s earnings over the last year. One way to conceptualize this is that for each €1 of shareholders’ capital it has, the company made €0.23 in profit.
Does Trajano Iberia Socimi 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. The limitation of this approach is that some companies are quite different from others, even within the same industry classification. As you can see in the graphic below, Trajano Iberia Socimi has a higher ROE than the average (8.3%) in the REITs industry.
BME:YTRA Past Revenue and Net Income May 14th 2020
That’s what we like to see. Bear in mind, a high ROE doesn’t always mean superior financial performance. 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 . Our risks dashboardshould have the 3 risks we have identified for Trajano Iberia Socimi.
How Does Debt Impact ROE?
Virtually all companies need money to invest in the business, to grow profits. That cash can come from issuing shares, retained earnings, or debt. 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.
Combining Trajano Iberia Socimi’s Debt And Its 23% Return On Equity
Trajano Iberia Socimi clearly uses a high amount of debt to boost returns, as it has a debt to equity ratio of 1.21. There’s no doubt the ROE is impressive, but it’s worth keeping in mind that the metric could have been lower if the company were to reduce its debt. Debt increases risk and reduces options for the company in the future, so you generally want to see some good returns from using it.
Summary
Return on equity is a useful indicator of the ability of a business to generate profits and return them to shareholders. Companies that can achieve high returns on equity without too much debt are generally of good quality. If two companies have the same ROE, then I would generally prefer the one with less debt.
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. Profit growth rates, versus the expectations reflected in the price of the stock, are a particularly important to consider. Check the past profit growth by Trajano Iberia Socimi 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.
If you spot an error that warrants correction, please contact the editor at editorial-team@simplywallst.com. This article by Simply Wall St is general in nature. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. Simply Wall St has no position in the stocks mentioned.
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