Posted on January 16, 2023
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 National Marine Dredging Company (ADX:NMDC), by way of a worked example.
ROE or return on equity is a useful tool to assess how effectively a company can generate returns on the investment it received from its shareholders. In short, ROE shows the profit each dollar generates with respect to its shareholder investments.
How To Calculate Return On Equity?
ROE can be calculated by using the formula:
Return on Equity = Net Profit (from continuing operations) ÷ Shareholders’ Equity
So, based on the above formula, the ROE for National Marine Dredging is:
20% = د.إ1.2b ÷ د.إ5.8b (Based on the trailing twelve months to June 2022).
The ‘return’ is the amount earned after tax over the last twelve months. One way to conceptualize this is that for each AED1 of shareholders’ capital it has, the company made AED0.20 in profit.
Does National Marine Dredging 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. Importantly, this is far from a perfect measure, because companies differ significantly within the same industry classification. As is clear from the image below, National Marine Dredging has a better ROE than the average (7.8%) in the Construction industry.
That’s clearly a positive. However, bear in mind that a high ROE doesn’t necessarily indicate efficient profit generation. Aside from changes in net income, a high ROE can also be the outcome of high debt relative to equity, which indicates risk.
How Does Debt Impact Return On Equity?
Most companies need money — from somewhere — to grow their profits. That cash can come from issuing shares, retained earnings, or debt. In the first two cases, the ROE will capture this use of capital to grow. 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 National Marine Dredging’s Debt And Its 20% Return On Equity
National Marine Dredging has a debt to equity ratio of 0.34, which is far from excessive. Its very respectable ROE, combined with only modest debt, suggests the business is in good shape. Judicious use of debt to improve returns can certainly be a good thing, although it does elevate risk slightly and reduce future optionality.
Return on equity is useful for comparing the quality of different businesses. In our books, the highest quality companies have high return on equity, despite low debt. All else being equal, a higher ROE is better.
Having said that, while ROE is a useful indicator of business quality, you’ll have to look at a whole range of factors to determine the right price to buy a stock. The rate at which profits are likely to grow, relative to the expectations of profit growth reflected in the current price, must be considered, too. You can see how the company has grow in the past by looking at this FREE detailed graph of past earnings, revenue and cash flow.