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. In other words, it is a profitability ratio which measures the rate of return on the capital provided by the company's shareholders.
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:
3.5% = €17m ÷ €488m (Based on the trailing twelve months to June 2023).
The 'return' is the amount earned after tax over the last twelve months. One way to conceptualize this is that for each €1 of shareholders' capital it has, the company made €0.03 in profit.
Does Ceconomy 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. The image below shows that Ceconomy has an ROE that is roughly in line with the Specialty Retail industry average (4.1%).
That's neither particularly good, nor bad. Although the ROE is similar to the industry, we should still perform further checks to see if the company's ROE is being boosted by high debt levels. If true, then it is more an indication of risk than the potential. Our risks dashboardshould have the 4 risks we have identified for Ceconomy.
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. Thus the use of debt can improve ROE, albeit along with extra risk in the case of stormy weather, metaphorically speaking.
Ceconomy's Debt And Its 3.5% ROE
It appears that Ceconomy makes extensive use of debt to improve its returns, because it has an alarmingly high debt to equity ratio of 5.37. We consider it to be a negative sign when a company has a rather low ROE despite a rather high debt to equity.