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). We’ll use the ROE to take a look at Pact Group Holdings Ltd (ASX: PGH), using a real-world example.

Return on equity or ROE is a test of how effectively a company increases its value and manages investor money. In other words, it reveals the company’s success in turning shareholders’ investments into profits.

See our latest analysis for Pact Group Holdings

How is the ROE calculated?

The formula for ROE is:

Return on equity = Net income (from continuing operations) ÷ Equity

Thus, based on the above formula, the ROE of Pact Group Holdings is:

20% = A $ 88 million ÷ A $ 432 million (based on the last twelve months to June 2021).

The “return” is the annual profit. This means that for every Australian dollar of equity, the company generated AUS $ 0.20 in profit.

Does Pact Group Holdings have a good ROE?

A simple way to determine if a company has a good return on equity is to compare it to the average in its industry. The limitation of this approach is that some companies are very different from others, even within the same industry classification. Fortunately, Pact Group Holdings has an above-average ROE (10%) for the packaging industry.

ASX: PGH Return on Equity September 22, 2021

This is what we love to see. Keep in mind that a high ROE doesn’t always mean superior financial performance. Besides changes in net income, high ROE can also be the result of high leverage to equity, which indicates risk. Our risk dashboard should include the 3 risks that we have identified for Pact Group Holdings.

Why You Should Consider Debt When Looking At ROE

Businesses generally need to invest money to increase their profits. This liquidity can come from the issuance of shares, retained earnings 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 the debt of Pact Group Holdings and its return on equity of 20%

Pact Group Holdings uses a large amount of debt to increase returns. Its debt to equity ratio is 1.52. While its ROE is respectable, it should be borne in mind that there is usually a limit on how much debt a business can use. Leverage increases risk and reduces options for the business in the future, so you usually want to get good returns using it.

Conclusion

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. If two companies have roughly the same level of debt to equity and one has a higher ROE, I would generally prefer the one with a higher ROE.

But ROE is only one piece of a bigger puzzle, as high-quality companies often trade at high earnings multiples. The rate at which earnings are likely to grow, relative to earnings growth expectations reflected in the current price, should also be considered. So you might want to check out this FREE visualization of analyst forecasts for the business.

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.

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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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