One of the best investments we can make is in our own knowledge and skills. With that in mind, this article will explain how we can use return on equity (ROE) to better understand a business. To keep the lesson grounded in practicality, we will use ROE to better understand Acquazzurra SpA (BIT:ACQ).
Return on equity or ROE is an important factor for a shareholder to consider as it tells them how much of their capital is being reinvested. In other words, it reveals the company’s success in turning shareholders’ investments into profits.
Discover our latest analysis for Acquazzurra
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 Acquazzurra is:
7.3% = €323,000 ÷ €4.4m (based on the last twelve months to December 2021).
“Yield” refers to a company’s earnings over the past year. This therefore means that for each €1 of investment by its shareholder, the company generates a profit of €0.07.
Does Acquazzurra have a good ROE?
A 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, as companies differ quite a bit within the same industry classification. As shown in the chart below, Acquazzurra has a below average ROE (43%) in the Multiline Retail industry classification.
That’s not what we like to see. However, we believe that a lower ROE could still mean that a company has the opportunity to improve its returns through the use of leverage, provided its existing debt levels are low. A company with high debt levels and low ROE is a combination we like to avoid given the risk involved. Our risk dashboard should have the 4 risks we identified for Acquazzurra.
What is the impact of debt on ROE?
Most businesses need money – from somewhere – to increase their profits. This money can come from retained earnings, issuing new stock (shares), or debt. In the first two cases, the ROE will capture this use of capital to grow. In the latter case, the debt necessary for growth will boost returns, but will not impact shareholders’ equity. This will make the ROE better than if no debt was used.
Combine Acquazzurra’s debt and its 7.3% return on equity
Although Acquazzurra has some debt, with a debt ratio of just 0.34, we wouldn’t say the debt is excessive. I’m not impressed with its ROE, but the debt levels aren’t too high, indicating the company has a decent outlook. Prudent use of debt to boost returns is generally a good move for shareholders, even if it leaves the company more exposed to rising interest rates.
Return on equity is a way to compare the business 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. If two companies have the same ROE, I would generally prefer the one with less debt.
But when a company is of high quality, the market often gives it a price that reflects that. The rate at which earnings are likely to grow, relative to earnings growth expectations reflected in the current price, should also be considered. So I think it’s worth checking it out free analyst forecast report for the company.
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.