While some investors are already familiar with financial metrics (hat trick), this article is for those who want to learn more about return on equity (ROE) and why it matters. Through learning-by-doing, we will examine ROE to better understand Hensoldt AG (ETR: 5UH).
Return on equity or ROE is an important factor for a shareholder to consider as it tells them how much of their capital is being reinvested. In other words, it reveals the company’s success in turning shareholders’ investments into profits.
Check out our latest analysis for Hensoldt
How is ROE calculated?
Return on equity can be calculated using the formula:
Return on equity = Net income (from continuing operations) ÷ Equity
So, based on the formula above, the ROE for Hensoldt is:
15% = €68m ÷ €466m (based on the last twelve months to March 2022).
“Yield” is the income the business has earned over the past year. This means that for every €1 of equity, the company generated €0.15 of profit.
Does Hensoldt have a good ROE?
Perhaps the easiest way to assess a company’s ROE is to compare it to the industry average. However, this method is only useful as a rough check, as companies differ quite a bit within the same industry classification. You can see in the graph below that Hensoldt has an ROE quite close to the Aerospace & Defense industry average (15%).
It’s neither particularly good nor bad. Although the ROE is similar to that of the industry, we still need to perform further checks to see if the company’s ROE is being boosted by high debt levels. If a company takes on too much debt, it runs a higher risk of defaulting on interest payments. You can see the 2 risks we have identified for Hensoldt by visiting our risk dashboard for free on our platform here.
The Importance of Debt to Return on Equity
Most businesses need money – from somewhere – to increase their profits. This money can come from retained earnings, issuing new stock (shares), or debt. In the first and second case, the ROE will reflect this use of cash for investment in the business. In the latter case, the debt necessary for growth will boost returns, but will not impact equity. This will make the ROE better than if no debt was used.
Combine Hensoldt’s debt and his 15% return on equity
Hensoldt uses a high amount of debt to increase returns. Its debt to equity ratio is 1.70. Although its ROE is quite respectable, the amount of debt the company is currently carrying is not ideal. Debt increases risk and reduces options for the business in the future, so you generally want to see good returns using it.
Summary
Return on equity is useful for comparing the quality of different companies. Companies that can earn high returns on equity without too much debt are generally of good quality. If two companies have the same ROE, I would generally prefer the one with less debt.
But ROE is only one piece of a larger puzzle, as high-quality companies often trade on high earnings multiples. Earnings growth rates, relative to expectations reflected in the share price, are particularly important to consider. You might want to check out this FREE analyst forecast visualization for the company.
Sure, you might find a fantastic investment by looking elsewhere. So take a look at this free list of interesting companies.
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This Simply Wall St article is general in nature. We provide commentary based on historical data and analyst forecasts only using unbiased methodology and our articles are not intended to be financial advice. It is not a recommendation to buy or sell stocks and does not take into account your objectives or financial situation. Our goal is to bring you targeted long-term analysis based on fundamental data. Note that our analysis may not take into account the latest announcements from price-sensitive companies or qualitative materials. Simply Wall St has no position in the stocks mentioned.
