While some investors are already familiar with financial metrics (hat tip), this article is for those who want to learn more about return on equity (ROE) and why it is important. As a learning by doing, we will look at the ROE to better understand Sebino SpA (BIT: SEB).
Return on equity or ROE is a test of how effectively a company increases its value and manages investor money. In other words, it is a profitability ratio that measures the rate of return on capital contributed by the shareholders of the company.
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How do you calculate return on equity?
The return on equity formula is:
Return on equity = Net income (from continuing operations) Ã· Equity
So, based on the above formula, Sebino’s ROE is:
42% = 7.5 million euros Ã· 18 million euros (based on the last twelve months up to December 2020).
The âreturnâ is the amount earned after tax over the past twelve months. One way to conceptualize this is that for every â¬ 1 of share capital it has, the company has made â¬ 0.42 in profit.
Does Sebino 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. Fortunately, Sebino has an above-average ROE (8.2%) for the commercial services industry.
This is what we love to see. That said, high ROE doesn’t always indicate high profitability. A higher proportion of debt in a company’s capital structure can also result in high ROE, where high debt levels could represent a huge risk. Our risk dashboard should include the 2 risks that we have identified for Sebino.
The importance of debt to return on equity
Businesses generally need to invest money to increase their profits. This liquidity can come from retained earnings, the issuance of new shares (shares) or debt. In the case of the first and second options, the ROE will reflect this use of cash, for growth. 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.
Combine Sebino’s debt and its 42% return on equity
Although Sebino has some debt, with a debt-to-equity ratio of just 0.57, we wouldn’t say the debt is excessive. Its ROE is very impressive, and given its modest debt, this suggests that the business is of high quality. The prudent use of debt to increase returns is generally good for shareholders, even if it leaves the company more exposed to interest rate hikes.
Return on equity is useful for comparing the 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. If two companies have the same ROE, then I would generally prefer the one with the least amount of debt.
But ROE is only one piece of a bigger puzzle, as high-quality companies often trade at high earnings multiples. It is important to take into account other factors, such as future profit growth and the amount of investment required for the future. So I think it’s worth checking this out free this detailed graphic past earnings, income and cash flow.
If you would rather consult with another company – one with potentially superior finances – then don’t miss this free list of interesting companies, which have a HIGH return on equity and low leverage.
This Simply Wall St article is general in nature. We provide commentary based on historical data and analyst forecasts using only unbiased methodology and our articles are not intended to be financial advice. 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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