While some investors are already well versed in financial metrics (hat tip), this article is for those who would like to learn about Return On Equity (ROE) and why it is important. We'll use ROE to examine Givaudan SA (VTX:GIVN), 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.
See our latest analysis for Givaudan
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 Givaudan is:
24% = CHF1.0b ÷ CHF4.3b (Based on the trailing twelve months to June 2024).
The 'return' is the profit over the last twelve months. That means that for every CHF1 worth of shareholders' equity, the company generated CHF0.24 in profit.
Does Givaudan 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. Importantly, this is far from a perfect measure, because companies differ significantly within the same industry classification. Pleasingly, Givaudan has a superior ROE than the average (19%) in the Chemicals industry.
That's clearly a positive. With that said, a high ROE doesn't always indicate high profitability. Aside from changes in net income, a high ROE can also be the outcome of high debt relative to equity, which indicates risk.
The Importance Of Debt To Return On Equity
Virtually all companies need money to invest in the business, to grow profits. That cash can come from retained earnings, issuing new shares (equity), or debt. 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 required for growth will boost returns, but will not impact the shareholders' equity. In this manner the use of debt will boost ROE, even though the core economics of the business stay the same.
Givaudan's Debt And Its 24% ROE
It's worth noting the high use of debt by Givaudan, leading to its debt to equity ratio of 1.14. While no doubt that its ROE is impressive, we would have been even more impressed had the company achieved this with lower debt. Debt does bring extra risk, so it's only really worthwhile when a company generates some decent returns from it.
Conclusion
Return on equity is one way we can compare its business quality of different companies. A company that can achieve a high return on equity without debt could be considered a high quality business. All else being equal, a higher ROE is better.