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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 Traton SE (ETR:8TRA), 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 Traton
How Do You 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 Traton is:
15% = €2.5b ÷ €16b (Based on the trailing twelve months to December 2023).
The 'return' is the income the business earned over the last year. One way to conceptualize this is that for each €1 of shareholders' capital it has, the company made €0.15 in profit.
Does Traton 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. You can see in the graphic below that Traton has an ROE that is fairly close to the average for the Machinery industry (14%).
That isn't amazing, but it is respectable. 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 true, then it is more an indication of risk than the potential. You can see the 2 risks we have identified for Traton by visiting our risks dashboard for free on our platform here.
How Does Debt Impact ROE?
Companies usually need to invest money to grow their profits. That cash can come from issuing shares, retained earnings, or debt. In the first two cases, the ROE will capture this use of capital to grow. In the latter case, the debt required for growth will boost returns, but will not impact the shareholders' equity. Thus the use of debt can improve ROE, albeit along with extra risk in the case of stormy weather, metaphorically speaking.
Combining Traton's Debt And Its 15% Return On Equity
It's worth noting the high use of debt by Traton, leading to its debt to equity ratio of 1.32. There's no doubt its ROE is decent, but the very high debt the company carries is not too exciting to see. 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.