Many investors are still learning about the various metrics that can be useful when analysing a stock. This article is for those who would like to learn about Return On Equity (ROE). We'll use ROE to examine MDA Ltd. (TSE:MDA), by way of a worked example.
Return on equity or ROE is a key measure used to assess how efficiently a company's management is utilizing the company's capital. Put another way, it reveals the company's success at turning shareholder investments into profits.
View our latest analysis for MDA
How Do You 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 MDA is:
1.8% = CA$18m ÷ CA$1.0b (Based on the trailing twelve months to September 2022).
The 'return' refers to a company's earnings over the last year. So, this means that for every CA$1 of its shareholder's investments, the company generates a profit of CA$0.02.
Does MDA Have A Good ROE?
One simple way to determine if a company has a good return on equity is to compare it to the average for its industry. However, this method is only useful as a rough check, because companies do differ quite a bit within the same industry classification. As is clear from the image below, MDA has a lower ROE than the average (8.8%) in the Aerospace & Defense industry.
That certainly isn't ideal. That being said, a low ROE is not always a bad thing, especially if the company has low leverage as this still leaves room for improvement if the company were to take on more debt. A company with high debt levels and low ROE is a combination we like to avoid given the risk involved.
How Does Debt Impact ROE?
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 and second cases, the ROE will reflect this use of cash for investment in the business. 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 MDA's Debt And Its 1.8% Return On Equity
MDA has a debt to equity ratio of 0.19, which is far from excessive. Its ROE is quite low, and the company already has some debt, so surely shareholders are hoping for an improvement. Conservative use of debt to boost returns is usually a good move for shareholders, though it does leave the company more exposed to interest rate rises.