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 Calida Holding AG (VTX:CALN), by way of a worked example.
Over the last twelve months Calida Holding has recorded a ROE of 8.9%. One way to conceptualize this, is that for each CHF1 of shareholders’ equity it has, the company made CHF0.089 in profit.
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How Do I Calculate Return On Equity?
The formula for ROE is:
Return on Equity = Net Profit ÷ Shareholders’ Equity
Or for Calida Holding:
8.9% = 14.638 ÷ CHF172m (Based on the trailing twelve months to June 2018.)
It’s easy to understand the ‘net profit’ part of that equation, but ‘shareholders’ equity’ requires further explanation. It is all the money paid into the company from shareholders, plus any earnings retained. Shareholders’ equity can be calculated by subtracting the total liabilities of the company from the total assets of the company.
What Does ROE Signify?
ROE looks at the amount a company earns relative to the money it has kept within the business. The ‘return’ is the yearly profit. A higher profit will lead to a higher ROE. So, as a general rule, a high ROE is a good thing. That means it can be interesting to compare the ROE of different companies.
Does Calida Holding Have A Good ROE?
One simple way to determine if a company has a good return on equity is to compare it to the average for its industry. However, this method is only useful as a rough check, because companies do differ quite a bit within the same industry classification. As is clear from the image below, Calida Holding has a lower ROE than the average (14%) in the Luxury industry.
Unfortunately, that’s sub-optimal. We’d prefer see an ROE above the industry average, but it might not matter if the company is undervalued. Nonetheless, it might be wise to check if insiders have been selling.
How Does Debt Impact ROE?
Companies usually need to invest money to grow their profits. The cash for investment can come from prior year profits (retained earnings), issuing new shares, or borrowing. 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 the returns, but will not change the equity. Thus the use of debt can improve ROE, albeit along with extra risk in the case of stormy weather, metaphorically speaking.