One of the best investments we can make is in our own knowledge and skills. With that in mind, this article will explain how we can use return on equity (ROE) to better understand a business. Learning by doing, we will look at ROE to better understand Zvi Sarfati & Sons Investments & Constructions Ltd. (TLV:SRFT).
Return on equity or ROE is a key metric used to gauge how effectively a company’s management is using the company’s capital. In other words, it is a profitability ratio that measures the rate of return on capital contributed by the company’s shareholders.
Check out our latest analysis for Zvi Sarfati & Sons Investments & Constructions
How do you calculate return on equity?
ROE can be calculated using the formula:
Return on equity = Net income (from continuing operations) ÷ Equity
So, based on the above formula, the ROE for Zvi Sarfati & Sons Investments & Constructions is:
13% = ₪36m ÷ ₪288m (Based on last twelve months to September 2021).
“Yield” is the income the business has earned over the past year. Another way to think about this is that for every 1₪ worth of equity, the company was able to earn 0.13₪ in profit.
Does Zvi Sarfati & Sons Investments & Constructions have a good return on equity?
By comparing a company’s ROE with the average for its industry, we can get a quick measure of its quality. The limitation of this approach is that some companies are very different from others, even within the same industrial classification. You can see in the graph below that Zvi Sarfati & Sons Investments & Constructions has an ROE quite close to the average for the Real Estate sector (11%).
It’s neither particularly good nor bad. Although at least the ROE is not lower than the industry, it is always worth checking the role that the company’s debt plays, since high levels of debt relative to equity can also give the impression that the ROE is high. If true, this is more an indication of risk than potential.
What is the impact of debt on ROE?
Companies generally need to invest money to increase their profits. This money 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, debt used for growth will enhance returns, but will not affect total equity. So using debt can improve ROE, but with the added risk of stormy weather, metaphorically speaking.
Combine the debt of Zvi Sarfati & Sons Investments & Constructions and its return on equity of 13%
Zvi Sarfati & Sons Investments & Constructions is clearly using a high amount of leverage to boost returns, as it has a leverage ratio of 1.42. While its ROE is respectable, it’s worth bearing in mind that there’s usually a limit to the amount of debt a company can use. Debt brings additional risk, so it’s only really worth it when a business is generating decent returns.
Return on equity is useful for comparing the quality of different companies. In our books, the highest quality companies have a high return on equity, despite low leverage. All things being equal, a higher ROE is better.
That said, while ROE is a useful indicator of a company’s quality, you’ll need to consider a whole host of factors to determine the right price to buy a stock. The rate at which earnings are likely to grow, relative to earnings growth expectations reflected in the current price, should also be considered. You can see how the company has grown in the past by watching this FREE detailed graph past profits, revenue and cash flow.
Sure Zvi Sarfati & Sons Investments & Constructions may not be the best stock to buy. So you might want to see this free collection of other companies that have high ROE and low debt.
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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.