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. As a learning-by-doing, we will look at ROE to better understand Termo2Power SA (WSE:T2P).
Return on Equity or ROE is a test of how effectively a company increases its value and manages investors’ money. In other words, it is a profitability ratio that measures the rate of return on capital contributed by the company’s shareholders.
See our latest review for Termo2Power
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 Termo2Power is:
6.4% = 82,000 zł ÷ 1.3 million zł (based on the last twelve months until March 2022).
The “yield” is the profit of the last twelve months. This means that for every 1 PLN value of equity, the company has generated 0.06 PLN of profit.
Does Termo2Power 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. However, this method is only useful as a rough check, as companies differ quite a bit within the same industry classification. You can see in the graph below that Termo2Power has an ROE quite close to the Machines industry average (7.9%).
So, although the ROE is not exceptional, it is at least acceptable. Even if the ROE is respectable compared to the industry, it is worth checking whether the company’s ROE is helped by high debt levels. If so, this increases its exposure to financial risk. Our risk dashboard should contain the 3 risks we have identified for Termo2Power.
What is the impact of debt on return on equity?
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 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 equity. So using debt can improve ROE, but with the added risk of stormy weather, metaphorically speaking.
Combine Termo2Power’s debt and its return on equity of 6.4%
Of note is Termo2Power’s heavy use of debt, leading to its debt-to-equity ratio of 1.48. With a fairly low ROE and a significant reliance on debt, it is difficult to get enthusiastic about this activity at the moment. Debt brings additional risk, so it’s only really worth it when a business is generating decent returns.
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. 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. Earnings growth rates, relative to expectations reflected in the share price, are particularly important to consider. Check Termo2Power’s past earnings growth by looking at 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.