Many investors are still educating themselves about 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 Karo Pharma AB (publ) (STO: KARO).
ROE or return on equity is a useful tool to assess how effectively a company can generate the returns on investment it has received from its shareholders. In other words, it is a profitability ratio that measures the rate of return on capital contributed by the shareholders of the company.
See our latest review for Karo Pharma
How is the ROE calculated?
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 of Karo Pharma is:
0.9% = 50m kr ÷ 5.8b kr (based on the last twelve months up to March 2021).
The “return” is the annual profit. This therefore means that for each SEK1 of the investments of its shareholder, the company generates a profit of SEK0.01.
Does Karo Pharma 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. As shown in the graph below, Karo Pharma has a lower than average ROE (12%) for the pharmaceutical industry classification.
It is certainly not ideal. However, a low ROE is not always bad. If the company’s debt levels are moderate to low, there is still a chance that returns can be improved through the use of financial leverage. A heavily leveraged company with a low ROE is a whole different story and a risky investment on our books. Our risk dashboard should contain the 2 risks that we have identified for Karo Pharma.
What is the impact of debt on ROE?
Businesses generally need to invest money to increase their profits. The money for the investment can come from the profits of the previous year (retained earnings), from the issuance of new shares or from loans. In the case of the first and second options, the ROE will reflect this use of cash, for growth. In the latter case, the debt necessary for growth will increase returns, but will have no impact on equity. This will make the ROE better than if no debt was used.
Combine Karo Pharma’s debt and its 0.9% return on equity
Noteworthy is Karo Pharma’s high reliance on debt, leading to its debt-to-equity ratio of 1.01. With a fairly low ROE and heavy use of debt, it’s hard to get excited about this business right now. Debt brings additional risk, so it’s only really worth it when a business is making decent returns from it.
Return on equity is a useful indicator of a company’s ability to generate profits and return them to shareholders. 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.
But when a company is of high quality, the market often offers it up to a price that reflects that. The rate at which earnings are likely to grow, relative to earnings growth expectations reflected in the current price, must also be considered. So I think it’s worth checking this out free this detailed graphic past earnings, income and cash flow.
But beware : Karo Pharma 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 documents. Simply Wall St has no position in the mentioned stocks.
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