One of the best investments we can make is in our own knowledge and skills. With that in mind, this article will discuss how we can use Return on Equity (ROE) to better understand a business. As a learning-by-doing, we’ll take a look at the ROE to better understand Shapir Engineering and Industry Ltd (TLV: SPEN).

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. Simply put, it is used to assess a company’s profitability against its equity.

Check out our latest analysis for Shapir Engineering and Industry

How is the ROE calculated?

ROE can be calculated using the formula:

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

So, based on the above formula, the ROE of Shapir Engineering and Industry is:

15% = ₪ 353m ÷ ₪ 2.3b (Based on the last twelve months up to September 2021).

The “return” is the profit of the last twelve months. This therefore means that for every 1 of its shareholder’s investments, the company generates a profit of ₪ 0.15.

Does Shapir Engineering and Industry have a good ROE?

An easy 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. The image below shows that Shapir Engineering and Industry has an ROE that is roughly in line with the construction industry average (16%).

TASE: SPEN Return on equity January 1, 2022

It’s no wonder, but it’s respectable. Although the ROE is similar to that of the industry, we still need to perform additional checks to see if the company’s ROE is being boosted by high levels of debt. If so, it increases their exposure to financial risk.

The importance of debt to return on equity

Almost all businesses need money to invest in the business, 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 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. In this way, the use of debt will increase the ROE, even if the basic economy of the business remains the same.

Shapir Engineering and Industry’s debt and its ROE of 15%

Shapir Engineering and Industry uses a large amount of debt to increase returns. It has a debt ratio of 2.24. 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. Investors should think carefully about how a business will perform if it weren’t able to borrow so easily, as credit markets change over time.

Summary

Return on equity is a way to compare the business quality of different companies. A business that can earn a high return on equity without going into debt can be considered a high quality business. 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.

That said, while ROE is a useful indicator of how good a business is, you’ll need to look at a whole range of factors to determine the right price to buy a stock. Especially important to consider are the growth rates of earnings, relative to expectations reflected in the stock price. You can see how the business has grown in the past by checking out this FREE detailed graphic past earnings, income and cash flow.

But beware : Shapir Engineering and Industry 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.

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 any stock 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 any of the stocks mentioned.

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