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’ll use ROE to better understand Belden Inc. (NYSE: BDC).
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 Belden
How to calculate return on equity?
the ROE formula is:
Return on equity = Net income (from continuing operations) ÷ Equity
So, based on the above formula, Belden’s ROE is:
6.5% = $62 million ÷ $956 million (based on trailing twelve months to December 2021).
The “return” is the annual profit. Another way to think about this is that for every dollar of equity, the company was able to make a profit of $0.07.
Does Belden 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 graph below, Belden has an ROE below the average (13%) of the electronics industry classification.
That’s not what we like to see. However, a low ROE is not always bad. If the company’s debt levels are moderate to low, there is always the possibility that returns could be enhanced through the use of leverage. A highly leveraged company with a low ROE is a whole other story and a risky investment on our books. You can see the 4 risks we have identified for Belden 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. This money can come from issuing stocks, retained earnings or debt. In the first and second case, the ROE will reflect this use of cash for investment in the business. 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.
Belden’s debt and its ROE of 6.5%
Of note is Belden’s heavy use of debt, leading to its debt-to-equity ratio of 1.53. The combination of a rather low ROE and heavy reliance on debt is not particularly attractive. 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 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.
That said, while ROE is a useful indicator of a company’s quality, you’ll need to consider a whole host of factors to determine the right price to buy a stock. The rate at which earnings are likely to grow, relative to earnings growth expectations reflected in the current price, should also be considered. You might want to take a look at this data-rich interactive chart of the company’s forecast.
But note: Belden may not be the best stock to buy. So take a look at this free list of interesting companies with high ROE 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.