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. As part of a learning-by-doing, we will examine ROE to better understand Chartwell Retirement Residences (TSE:CSH.UN).
Return on equity or ROE is a key metric used to gauge how effectively a company’s management is using the company’s capital. In other words, it is a profitability ratio that measures the rate of return on capital contributed by the company’s shareholders.
Our analysis indicates that CSH.UN is potentially undervalued!
How to calculate return on equity?
The ROE formula is:
Return on equity = Net income (from continuing operations) ÷ Equity
So, according to the formula above, the ROE for Chartwell Retirement Residences is:
0.5% = C$4.0 million ÷ C$772 million (based on trailing 12 months to June 2022).
“Yield” is the income the business has earned over the past year. This means that for every Canadian dollar of equity, the company generated a profit of 0.01 Canadian dollars.
Do Chartwell Retirement Residences 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. As shown in the graph below, Chartwell Retirement Residences has a below average ROE (4.8%) in the healthcare industry classification.
It’s certainly not ideal. 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 that its existing debt levels are low. A highly leveraged company with a low ROE is a whole other story and a risky investment on our books. You can see the 3 risks we have identified for Chartwell retirement residences by visiting our risk dashboard for free on our platform here.
The Importance of Debt to Return on Equity
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 and second case, the ROE will reflect this use of cash for investment in the business. In the latter case, the use of debt will improve returns, but will not change equity. In this way, the use of debt will increase ROE, even though the core economics of the business remains the same.
The debt of Chartwell Residences for retirees and its ROE of 0.5%
It appears that Chartwell Retirement Residences is relying heavily on debt to boost its returns, as its debt-to-equity ratio is an alarming 3.13. Most investors would need a low share price to be interested in a company with low ROE and high debt to equity.
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. 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 ROE is only one piece of a larger puzzle, as high-quality companies often trade on high earnings multiples. 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 check out this FREE analyst forecast visualization for the company.
Sure, you might find a fantastic investment by looking elsewhere. So take a look at this free list of interesting companies.
Valuation is complex, but we help make it simple.
Find out if Chartwell Retirement Residences is potentially overvalued or undervalued by viewing our full analysis, which includes fair value estimates, risks and warnings, dividends, insider trading and financial health.
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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.