Many investors are still educating themselves on the various metrics that can be useful when analyzing a stock. This article is for those who want to learn more about return on equity (ROE). As a learning by doing, we will look at the ROE to better understand Construcciones y Auxiliar de Ferrocarriles, SA (BME: CAF).
Return on equity or ROE is a test of how effectively a company increases its value and manages investor money. Simply put, it is used to assess a company’s profitability against its equity.
See our latest review for Construcciones y Auxiliar de Ferrocarriles
How to calculate return on equity?
Return on equity can be calculated using the formula:
Return on equity = Net income (from continuing operations) ÷ Equity
Thus, based on the above formula, the ROE for Construcciones y Auxiliar de Ferrocarriles is:
8.9% = 58 million euros ÷ 644 million euros (based on the last twelve months up to March 2021).
The “return” is the annual profit. This means that for every € 1 of equity, the company generated € 0.09 in profit.
Does Construcciones y Auxiliar de Ferrocarriles have a good return on equity?
By comparing a company’s ROE with its industry average, we can get a quick measure of its quality. It is important to note that this measure is far from perfect, as companies differ considerably within a single industry classification. The image below shows that Construcciones y Auxiliar de Ferrocarriles has an ROE that is roughly in line with the machinery sector average (9.6%).
So, if the ROE is not exceptional, at least it is acceptable. Even though the ROE is respectable compared to the industry, it is worth checking out if the company’s ROE is helped by high debt levels. If this is true, it is more an indication of risk than potential.
What is the impact of debt on return on equity?
Most businesses need money – from somewhere – to increase their profits. This liquidity can come from retained earnings, the issuance of 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 returns, but will not affect equity. In this way, the use of debt will increase the ROE, even if the basic economy of the business remains the same.
The debt of Construcciones y Auxiliar de Ferrocarriles and its ROE of 8.9%
Construcciones y Auxiliar de Ferrocarriles uses a large amount of debt to increase returns. Its debt to equity ratio is 1.52. The combination of a rather low ROE and a high recourse to debt is not particularly attractive. Leverage increases risk and reduces options for the business in the future, so you usually want to get good returns using it.
Return on equity is a way to compare the business quality of different companies. A business that can earn a high return on equity without going into debt could be considered a high quality business. All other things being equal, a higher ROE is preferable.
That said, while ROE is a useful indicator of how good a business is, you’ll need to look at a whole range of factors to determine the right price to buy a stock. It is important to take into account other factors, such as future profit growth and the amount of investment required for the future. So you might want to check out this FREE visualization of analyst forecasts for the business.
But beware : Construcciones y Auxiliar de Ferrocarriles may not be the best stock to buy. So take a look at this free list of interesting companies with high ROE and low debt.
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This Simply Wall St article is general in nature. It does not constitute a recommendation to buy or sell shares and does not take into account your goals or your financial situation. Our aim is to bring you long-term, targeted analysis based on fundamental data. Note that our analysis may not take into account the latest announcements from price sensitive companies or qualitative material. Simply Wall St has no position in the mentioned stocks.
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