While some investors are already well versed in financial metrics (hat tip), this article is for those who would like to learn about Return On Equity (ROE) and why it is important. We'll use ROE to examine Francotyp-Postalia Holding AG (ETR:FPH), by way of a worked example.
Return on Equity or ROE is a test of how effectively a company is growing its value and managing investors’ money. Simply put, it is used to assess the profitability of a company in relation to its equity capital.
Check out our latest analysis for Francotyp-Postalia Holding
How Is ROE Calculated?
The formula for return on equity is:
Return on Equity = Net Profit (from continuing operations) ÷ Shareholders' Equity
So, based on the above formula, the ROE for Francotyp-Postalia Holding is:
9.3% = €2.6m ÷ €28m (Based on the trailing twelve months to March 2023).
The 'return' is the income the business earned over the last year. That means that for every €1 worth of shareholders' equity, the company generated €0.09 in profit.
Does Francotyp-Postalia Holding Have A Good Return On Equity?
Arguably the easiest way to assess company's ROE is to compare it with the average in its industry. However, this method is only useful as a rough check, because companies do differ quite a bit within the same industry classification. You can see in the graphic below that Francotyp-Postalia Holding has an ROE that is fairly close to the average for the Commercial Services industry (8.1%).
That isn't amazing, but it is respectable. Although the ROE is similar to the industry, we should still perform further checks to see if the company's ROE is being boosted by high debt levels. If so, this increases its exposure to financial risk. Our risks dashboardshould have the 2 risks we have identified for Francotyp-Postalia Holding.
The Importance Of Debt To Return On Equity
Companies usually need to invest money to grow their profits. That cash can come from issuing shares, retained earnings, or debt. In the first and second cases, the ROE will reflect this use of cash for investment in the business. In the latter case, the debt required for growth will boost returns, but will not impact the shareholders' equity. That will make the ROE look better than if no debt was used.
Combining Francotyp-Postalia Holding's Debt And Its 9.3% Return On Equity
Francotyp-Postalia Holding clearly uses a high amount of debt to boost returns, as it has a debt to equity ratio of 1.49. Its ROE is quite low, even with the use of significant debt; that's not a good result, in our opinion. Debt increases risk and reduces options for the company in the future, so you generally want to see some good returns from using it.