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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 Hensoldt AG (ETR:HAG), 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. Simply put, it is used to assess the profitability of a company in relation to its equity capital.
View our latest analysis for Hensoldt
How Is ROE Calculated?
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 Hensoldt is:
1.5% = €11m ÷ €726m (Based on the trailing twelve months to September 2024).
The 'return' is the profit over the last twelve months. One way to conceptualize this is that for each €1 of shareholders' capital it has, the company made €0.02 in profit.
Does Hensoldt Have A Good Return On Equity?
By comparing a company's ROE with its industry average, we can get a quick measure of how good it is. However, this method is only useful as a rough check, because companies do differ quite a bit within the same industry classification. If you look at the image below, you can see Hensoldt has a lower ROE than the average (19%) in the Aerospace & Defense industry classification.
Unfortunately, that's sub-optimal. Although, we think that a lower ROE could still mean that a company has the opportunity to better its returns with the use of leverage, provided its existing debt levels are low. A company with high debt levels and low ROE is a combination we like to avoid given the risk involved. To know the 2 risks we have identified for Hensoldt visit our risks dashboard for free.
The Importance Of Debt To Return On Equity
Most companies need money -- from somewhere -- to grow their profits. The cash for investment can come from prior year profits (retained earnings), issuing new shares, or borrowing. In the case of the first and second options, the ROE will reflect this use of cash, for growth. In the latter case, the debt used for growth will improve returns, but won't affect the total equity. That will make the ROE look better than if no debt was used.
Combining Hensoldt's Debt And Its 1.5% Return On Equity
Hensoldt clearly uses a high amount of debt to boost returns, as it has a debt to equity ratio of 1.51. The combination of a rather low ROE and significant use of debt is not particularly appealing. Investors should think carefully about how a company might perform if it was unable to borrow so easily, because credit markets do change over time.