In This Article:
One of the best investments we can make is in our own knowledge and skill set. With that in mind, this article will work through how we can use Return On Equity (ROE) to better understand a business. We'll use ROE to examine Ceconomy AG (ETR:CEC), 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. Simply put, it is used to assess the profitability of a company in relation to its equity capital.
See our latest analysis for Ceconomy
How Do You Calculate Return On Equity?
Return on equity can be calculated by using the formula:
Return on Equity = Net Profit (from continuing operations) ÷ Shareholders' Equity
So, based on the above formula, the ROE for Ceconomy is:
27% = €136m ÷ €508m (Based on the trailing twelve months to June 2024).
The 'return' is the amount earned after tax over the last twelve months. So, this means that for every €1 of its shareholder's investments, the company generates a profit of €0.27.
Does Ceconomy Have A Good Return On Equity?
One simple way to determine if a company has a good return on equity is to compare it to the average for its industry. Importantly, this is far from a perfect measure, because companies differ significantly within the same industry classification. Pleasingly, Ceconomy has a superior ROE than the average (14%) in the Specialty Retail industry.
That's what we like to see. Bear in mind, a high ROE doesn't always mean superior financial performance. Aside from changes in net income, a high ROE can also be the outcome of high debt relative to equity, which indicates risk. You can see the 2 risks we have identified for Ceconomy by visiting our risks dashboard for free on our platform here.
The Importance Of Debt To Return On Equity
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 Ceconomy's Debt And Its 27% Return On Equity
It seems that Ceconomy uses a huge volume of debt to fund the business, since it has an extremely high debt to equity ratio of 5.28. So although the company has an impressive ROE, the company might not have been able to achieve this without the significant use of debt.