One of the best investments we can make is in our own knowledge and skill set. With that in mind, this article will work through 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 Linamar Corporation (TSE:LNR).
Over the last twelve months
Linamar has recorded a ROE of 17%. Another way to think of that is that for every CA$1 worth of equity in the company, it was able to earn CA$0.17.
How Do You Calculate Return On Equity?
formula for return on equity is:
Return on Equity = Net Profit ÷ Shareholders’ Equity
Or for Linamar:
17% = CA$596m ÷ CA$3.5b (Based on the trailing twelve months to June 2018.)
Most readers would understand what net profit is, but it’s worth explaining the concept of shareholders’ equity. It is all the money paid into the company from shareholders, plus any earnings retained. The easiest way to calculate shareholders’ equity is to subtract the company’s total liabilities from the total assets.
What Does Return On Equity Signify?
Return on Equity measures a company’s profitability against the profit it has kept for the business (plus any capital injections). The ‘return’ is the profit over the last twelve months. That means that the higher the ROE, the more profitable the company is. So, as a general rule,
a high ROE is a good thing. That means ROE can be used to compare two businesses.
Does Linamar Have A Good ROE?
One 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, because companies do differ quite a bit within the same industry classification. You can see in the graphic below that Linamar has an ROE that is fairly close to the average for the auto components industry (15%).
That’s not overly surprising. Generally it will take a while for decisions made by leadership to impact the ROE. So it makes sense to
Why You Should Consider Debt When Looking At ROE
Most companies need money — from somewhere — to grow their profits. The cash for investment can come from prior year profits (retained earnings), issuing new shares, or borrowing. In the first and second cases, the ROE will reflect this use of cash for investment in the business. In the latter case, the use of debt will improve the returns, but will not change the equity. Thus the use of debt can improve ROE, albeit along with extra risk in the case of stormy weather, metaphorically speaking.
Combining Linamar’s Debt And Its 17% Return On Equity
While Linamar does have some debt, with debt to equity of just 0.73, we wouldn’t say debt is excessive. The fact that it achieved a fairly good ROE with only modest debt suggests the business might be worth putting on your watchlist. Careful use of debt to boost returns is often very good for shareholders. However, it could reduce the company’s ability to take advantage of future opportunities.
Return on equity is useful for comparing the quality of different businesses. Companies that can achieve high returns on equity without too much debt are generally of good quality. All else being equal, a higher ROE is better.
Having said that, while ROE is a useful indicator of business quality, you’ll have to look at a whole range of factors to determine the right price to buy a stock. Profit growth rates, versus the expectations reflected in the price of the stock, are a particularly important to consider. So you might want to take a peek at this data-rich interactive graph of forecasts for the company.
Linamar may not be the best stock to buy. So you may wish to see this >free collection of other companies that have high ROE and low debt.
>free collection of other companies that have high ROE and low debt.
To help readers see past the short term volatility of the financial market, we aim to bring you a long-term focused research analysis purely driven by fundamental data. Note that our analysis does not factor in the latest price-sensitive company announcements.
The author is an independent contributor and at the time of publication had no position in the stocks mentioned. For errors that warrant correction please contact the editor at firstname.lastname@example.org.
Source : https://finance.yahoo.com/news/return-equity-17-linamar-corporation-132657566.html