Boasting A 21% Return On Equity, Is RHI Magnesita N.V. (LON:RHIM) A Top Quality Stock?
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Many investors are still learning about the various metrics that can be useful when analysing a stock. This article is for those who would like to learn about Return On Equity (ROE). We'll use ROE to examine RHI Magnesita N.V. (LON:RHIM), by way of a worked example.
RHI Magnesita has a ROE of 21%, based on the last twelve months. Another way to think of that is that for every £1 worth of equity in the company, it was able to earn £0.21.
See our latest analysis for RHI Magnesita
How Do I Calculate ROE?
The formula for ROE is:
Return on Equity = Net Profit ÷ Shareholders' Equity
Or for RHI Magnesita:
21% = €158m ÷ €885m (Based on the trailing twelve months to December 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. You can calculate shareholders' equity by subtracting the company's total liabilities from its total assets.
What Does Return On Equity Signify?
ROE looks at the amount a company earns relative to the money it has kept within the business. The 'return' is the profit over the last twelve months. A higher profit will lead to a higher ROE. So, as a general rule, a high ROE is a good thing. Clearly, then, one can use ROE to compare different companies.
Does RHI Magnesita 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. Importantly, this is far from a perfect measure, because companies differ significantly within the same industry classification. As is clear from the image below, RHI Magnesita has a better ROE than the average (17%) in the Basic Materials industry.
That's clearly a positive. In my book, a high ROE almost always warrants a closer look. For example, I often check if insiders have been buying shares .
How Does Debt Impact ROE?
Virtually all companies need money to invest in the business, to grow 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 debt required for growth will boost returns, but will not impact the shareholders' equity. In this manner the use of debt will boost ROE, even though the core economics of the business stay the same.
RHI Magnesita's Debt And Its 21% ROE
It's worth noting the significant use of debt by RHI Magnesita, leading to its debt to equity ratio of 1.33. while its ROE is respectable, it is worth keeping in mind that there is usually a limit to how much debt a company can use. Debt does bring extra risk, so it's only really worthwhile when a company generates some decent returns from it.
But It's Just One Metric
Return on equity is useful for comparing the quality of different businesses. In my book the highest quality companies have high return on equity, despite low debt. If two companies have around the same level of debt to equity, and one has a higher ROE, I'd generally prefer the one with higher ROE.
But when a business is high quality, the market often bids it up to a price that reflects this. Profit growth rates, versus the expectations reflected in the price of the stock, are a particularly important to consider. So I think it may be worth checking this free report on analyst forecasts for the company.
But note: RHI Magnesita may not be the best stock to buy. So take a peek at this free list of interesting companies with high ROE and low debt.
We aim to bring you long-term focused research analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material.
If you spot an error that warrants correction, please contact the editor at editorial-team@simplywallst.com. This article by Simply Wall St is general in nature. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. Simply Wall St has no position in the stocks mentioned. Thank you for reading.
