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 Park & Bellheimer AG (FRA:PKB), 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.
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How To 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 Park & Bellheimer is:
8.9% = €910k ÷ €10m (Based on the trailing twelve months to June 2022).
The 'return' refers to a company's earnings over the last year. That means that for every €1 worth of shareholders' equity, the company generated €0.09 in profit.
Does Park & Bellheimer 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. However, this method is only useful as a rough check, because companies do differ quite a bit within the same industry classification. If you look at the image below, you can see Park & Bellheimer has a similar ROE to the average in the Beverage industry classification (9.4%).
That's neither particularly good, nor bad. While at least the ROE is not lower than the industry, its still worth checking what role the company's debt plays as high debt levels relative to equity may also make the ROE appear high. If so, this increases its exposure to financial risk. Our risks dashboardshould have the 4 risks we have identified for Park & Bellheimer.
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 use of debt will improve the returns, but will not change the equity. Thus the use of debt can improve ROE, albeit along with extra risk in the case of stormy weather, metaphorically speaking.
Park & Bellheimer's Debt And Its 8.9% ROE
Park & Bellheimer does use a high amount of debt to increase returns. It has a debt to equity ratio of 1.25. The combination of a rather low ROE and significant use of debt is not particularly appealing. Debt increases risk and reduces options for the company in the future, so you generally want to see some good returns from using it.