While some investors are already familiar with financial metrics (hat trick), this article is for those who want to learn more about return on equity (ROE) and why it matters. We will use ROE to examine CIE Automotive, SA (BME:CIE), through a concrete example.
ROE or return on equity is a useful tool for evaluating how effectively a company can generate returns on the investment it has received from its shareholders. In other words, it reveals the company’s success in turning shareholders’ investments into profits.
Check opportunities and risks within the XX Auto Components industry.
How is ROE calculated?
The return on equity formula is:
Return on equity = Net income (from continuing operations) ÷ Equity
So, based on the above formula, the ROE for CIE Automotive is:
20% = €313M ÷ €1.5B (based on the last twelve months until June 2022).
The “return” is the annual profit. Another way to think about this is that for every €1 of equity, the company was able to make €0.20 in profit.
Does CIE Automotive have a good return on equity?
By comparing a company’s ROE with the average for its industry, we can get a quick measure of its quality. It is important to note that this measure is far from perfect, as companies differ significantly within the same industry classification. As you can see in the graph below, CIE Automotive has an above average ROE (7.7%) for the automotive components industry.
This is clearly a positive point. That said, a high ROE does not always mean high profitability. Especially when a company uses high levels of debt to finance its debt, which can increase its ROE, but the high leverage puts the company at risk. You can see the 2 risks we have identified for CIE Automotive by visiting our risk dashboard for free on our platform here.
What is the impact of debt on ROE?
Virtually all businesses need money to invest in the business, to increase their profits. The money for the investment can come from the previous year’s earnings (retained earnings), from issuing new shares or from borrowing. In the first two cases, the ROE will capture this use of capital to grow. In the latter case, the use of debt will improve returns, but will not change equity. This will make the ROE better than if no debt was used.
CIE Automotive’s debt and its ROE of 20%
Note the heavy use of debt by CIE Automotive, leading to its debt-to-equity ratio of 1.37. Although its ROE is quite respectable, the amount of debt the company is currently carrying is not ideal. Investors need to think carefully about how a company would perform if it weren’t able to borrow so easily, as credit markets change over time.
Return on equity is useful for comparing the quality of different companies. A company that can earn a high return on equity without going into debt could be considered a high quality company. All things being equal, a higher ROE is better.
But when a company is of high quality, the market often gives it a price that reflects that. It is important to consider other factors, such as future earnings growth and the amount of investment needed in the future. You might want to take a look at this data-rich interactive chart of the company’s forecast.
Sure, you might find a fantastic investment by looking elsewhere. So take a look at this free list of interesting companies.
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This Simply Wall St article is general in nature. We provide commentary based on historical data and analyst forecasts only using unbiased methodology and our articles are not intended to be financial advice. It is not a recommendation to buy or sell stocks and does not take into account your objectives or financial situation. Our goal is to bring you targeted long-term analysis based on fundamental data. Note that our analysis may not take into account the latest announcements from price-sensitive companies or qualitative materials. Simply Wall St has no position in the stocks mentioned.
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