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 Novavest Real Estate AG (VTX:NREN), 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 simpler terms, it measures the profitability of a company in relation to shareholder's equity.
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How To 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 Novavest Real Estate is:
4.5% = CHF19m ÷ CHF423m (Based on the trailing twelve months to December 2024).
The 'return' is the income the business earned over the last year. So, this means that for every CHF1 of its shareholder's investments, the company generates a profit of CHF0.05.
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Does Novavest Real Estate Have A Good ROE?
Arguably the easiest way to assess company's ROE is to compare it with the average in its industry. However, this method is only useful as a rough check, because companies do differ quite a bit within the same industry classification. As shown in the graphic below, Novavest Real Estate has a lower ROE than the average (6.5%) in the Real Estate industry classification.
That's not what we like to see. That being said, a low ROE is not always a bad thing, especially if the company has low leverage as this still leaves room for improvement if the company were to take on more debt. When a company has low ROE but high debt levels, we would be cautious as the risk involved is too high. Our risks dashboard should have the 3 risks we have identified for Novavest Real Estate.
How Does Debt Impact 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 first two cases, the ROE will capture this use of capital to grow. In the latter case, the use of debt will improve the returns, but will not change the equity. That will make the ROE look better than if no debt was used.
Novavest Real Estate's Debt And Its 4.5% ROE
Novavest Real Estate clearly uses a high amount of debt to boost returns, as it has a debt to equity ratio of 1.32. Its ROE is quite low, even with the use of significant debt; that's not a good result, in our opinion. 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.