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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 Deutsche Lufthansa AG (ETR:LHA), by way of a worked example.
Return on equity or ROE is an important factor to be considered by a shareholder because it tells them how effectively their capital is being reinvested. In other words, it is a profitability ratio which measures the rate of return on the capital provided by the company's shareholders.
Check out our latest analysis for Deutsche Lufthansa
How Do You 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 Deutsche Lufthansa is:
18% = €1.9b ÷ €10b (Based on the trailing twelve months to September 2023).
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 €0.18.
Does Deutsche Lufthansa Have A Good Return On Equity?
Arguably the easiest way to assess company's ROE is to compare it with the average in its industry. Importantly, this is far from a perfect measure, because companies differ significantly within the same industry classification. As shown in the graphic below, Deutsche Lufthansa has a lower ROE than the average (38%) in the Airlines 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.
The Importance Of Debt To Return On Equity
Companies usually need to invest money to grow their profits. That cash can come from retained earnings, issuing new shares (equity), 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 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.
Deutsche Lufthansa's Debt And Its 18% ROE
It's worth noting the high use of debt by Deutsche Lufthansa, leading to its debt to equity ratio of 1.16. While its ROE is respectable, it is worth keeping in mind that there is usually a limit as to how much debt a company can use. Debt does bring extra risk, so it's only really worthwhile when a company generates some decent returns from it.