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). To keep the lesson practical, we will use the ROE to better understand Exel Composites Oyj (HEL: EXL1V).
Return on equity or ROE is a test of how effectively a company increases its value and manages investor money. In short, the ROE shows the profit that each dollar generates compared to the investments of its shareholders.
Check out our latest review for Exel Composites Oyj
How do you calculate return on equity?
Return on equity can be calculated using the formula:
Return on equity = Net income (from continuing operations) ÷ Equity
So, based on the above formula, the ROE for Exel Composites Oyj is:
23% = 6.7 million euros ÷ 29 million euros (based on the last twelve months up to March 2021).
The “return” is the income the business has earned over the past year. This means that for every € 1 of equity, the company generated € 0.23 in profit.
Does Exel Composites Oyj have a good return on equity?
Perhaps the easiest way to assess a company’s ROE is to compare it to the industry average. The limitation of this approach is that some companies are very different from others, even within the same industry classification. As shown in the image below, Exel Composites Oyj has a better ROE than the average (11%) in the machinery industry.
It’s a good sign. Keep in mind that a high ROE doesn’t always mean superior financial performance. 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. To know the 2 risks that we have identified for Exel Composites Oyj, visit our free risk dashboard.
What is the impact of debt on ROE?
Most businesses need money – from somewhere – to increase their profits. The cash to be invested can come from the profits of the previous year (retained earnings), from the issuance of new shares or from loans. In the first and second cases, the ROE will reflect this use of cash for investing in the business. In the latter case, the debt used for growth will improve returns, but will not affect total equity. So, using debt can improve ROE, but with added risk in stormy weather, metaphorically speaking.
Combine Exel Composites Oyj’s debt and its 23% return on equity
Exel Composites Oyj uses a large amount of debt to increase returns. Its debt ratio is 1.38. While there is no doubt that its ROE is impressive, we would have been even more impressed if the company had achieved this goal with lower debt. Investors should think carefully about how a business will perform if it was not able to borrow so easily, as credit markets change over time.
Return on equity is a useful indicator of a company’s ability to generate profits and return them to shareholders. In our books, the highest quality companies have a high return on equity, despite low leverage. If two companies have the same ROE, then I would generally prefer the one with the least amount of debt.
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, should also be considered. You might want to take a look at this data-rich interactive chart of the forecast 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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