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 Elma Electronic AG (VTX:ELMN), by way of a worked example.
Return on Equity or ROE is a test of how effectively a company is growing its value and managing investors’ money. In short, ROE shows the profit each dollar generates with respect to its shareholder investments.
Check out our latest analysis for Elma Electronic
How To Calculate Return On Equity?
ROE 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 Elma Electronic is:
13% = CHF6.7m ÷ CHF53m (Based on the trailing twelve months to June 2022).
The 'return' is the profit over the last twelve months. Another way to think of that is that for every CHF1 worth of equity, the company was able to earn CHF0.13 in profit.
Does Elma Electronic 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. Importantly, this is far from a perfect measure, because companies differ significantly within the same industry classification. The image below shows that Elma Electronic has an ROE that is roughly in line with the Electronic industry average (14%).
That's neither particularly good, nor bad. Even if the ROE is respectable when compared to the industry, its worth checking if the firm's ROE is being aided by high debt levels. If true, then it is more an indication of risk than the potential.
Why You Should Consider Debt When Looking At ROE
Most companies need money -- from somewhere -- to grow their 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.
Combining Elma Electronic's Debt And Its 13% Return On Equity
While Elma Electronic does have some debt, with a debt to equity ratio of just 0.37, we wouldn't say debt is excessive. Its very respectable ROE, combined with only modest debt, suggests the business is in good shape. Conservative use of debt to boost returns is usually a good move for shareholders, though it does leave the company more exposed to interest rate rises.