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. To keep the lesson grounded in practicality, we will use ROE to better understand Amot Investment Ltd (TLV:AMOT).
Return on Equity or ROE is a test of how effectively a company increases its value and manages investors’ money. In simple terms, it is used to assess the profitability of a company in relation to its equity.
Check out our latest analysis for Amot Investment
How do you calculate return on equity?
ROE can be calculated using the formula:
Return on equity = Net income (from continuing operations) ÷ Equity
So, based on the above formula, the ROE for Amot Investment is:
5.4% = ₪384 million ÷ ₪7.1 billion (based on the last twelve months to September 2021).
The “return” is the annual profit. Another way to think about this is that for every 1₪ worth of equity, the company was able to earn 0.05₪ in profit.
Does Amot Investment have a good return on equity?
Perhaps the easiest way to assess a company’s ROE is to compare it to the industry average. The limitation of this approach is that some companies are very different from others, even within the same industrial classification. As shown in the graph below, Amot Investment has a below average ROE (11%) in the real estate industry classification.
Unfortunately, this is suboptimal. That being said, a low ROE is not always a bad thing, especially if the company has low debt, as it still leaves room for improvement if the company were to take on more debt. When a company has a low ROE but a high level of debt, we would be cautious because the risk involved is too high. You can see the 5 risks we have identified for Amot Investment by visiting our risk dashboard for free on our platform here.
Why You Should Consider Debt When Looking at ROE
Virtually all businesses need money to invest in the business, to increase their profits. This money can come from issuing shares, retained earnings or debt. In the case of the first and second options, the ROE will reflect this use of cash, for growth. In the latter case, debt used for growth will enhance returns, but will not affect total equity. In this way, the use of debt will increase ROE, even though the core economics of the business remains the same.
Combine Amot Investment’s debt and its return on equity of 5.4%
Amot Investment is clearly using a high amount of debt to increase returns, as its debt-to-equity ratio is 1.08. Its ROE is quite low, even with the use of significant debt; this is not a good result, in our view. Debt increases risk and reduces options for the business in the future, so you generally want to see good returns using it.
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 roughly the same level of debt and one has a higher ROE, I generally prefer the one with a higher ROE.
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. Check Amot Investment’s past earnings growth by viewing this visualization of past earnings, revenue, and cash flow.
If you’d rather check out another company – one with potentially superior finances – then don’t miss this free list of attractive companies, which have a high return on equity and low debt.
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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.