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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 Traton SE (ETR:8TRA), by way of a worked example.
Return on equity or ROE is an important factor to be considered by a shareholder because it tells them how effectively their capital is being reinvested. In short, ROE shows the profit each dollar generates with respect to its shareholder investments.
Check out our latest analysis for Traton
How Do You 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 Traton is:
15% = €2.6b ÷ €17b (Based on the trailing twelve months to September 2024).
The 'return' is the yearly profit. So, this means that for every €1 of its shareholder's investments, the company generates a profit of €0.15.
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. Pleasingly, Traton has a superior ROE than the average (10%) in the Machinery industry.
That's clearly a positive. Bear in mind, a high ROE doesn't always mean superior financial performance. Especially when a firm uses high levels of debt to finance its debt which may boost its ROE but the high leverage puts the company at risk. 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 Return On Equity?
Most companies need money -- from somewhere -- to grow their profits. The cash for investment can come from prior year profits (retained earnings), issuing new shares, or borrowing. In the first two cases, the ROE will capture this use of capital to grow. In the latter case, the debt used for growth will improve returns, but won't affect the total equity. That will make the ROE look better than if no debt was used.
Combining Traton's Debt And Its 15% Return On Equity
Traton clearly uses a high amount of debt to boost returns, as it has a debt to equity ratio of 1.46. While its ROE is pretty respectable, the amount of debt the company is carrying currently is not ideal. Debt does bring extra risk, so it's only really worthwhile when a company generates some decent returns from it.