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Is Cardno Limited's (ASX:CDD) 2.9% ROE Worse Than Average?

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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 Cardno Limited (ASX:CDD), by way of a worked example.

Cardno has a ROE of 2.9%, based on the last twelve months. That means that for every A$1 worth of shareholders' equity, it generated A$0.029 in profit.

View our latest analysis for Cardno

How Do You Calculate Return On Equity?

The formula for return on equity is:

Return on Equity = Net Profit ÷ Shareholders' Equity

Or for Cardno:

2.9% = AU$16m ÷ AU$535m (Based on the trailing twelve months to December 2018.)

Most know that net profit is the total earnings after all expenses, but the concept of shareholders' equity is a little more complicated. It is all earnings retained by the company, plus any capital paid in by shareholders. You can calculate shareholders' equity by subtracting the company's total liabilities from its total assets.

What Does ROE Mean?

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 yearly profit. A higher profit will lead to a higher ROE. So, as a general rule, a high ROE is a good thing. That means ROE can be used to compare two businesses.

Does Cardno Have A Good Return On Equity?

Arguably the easiest way to assess company's ROE is to compare it with the average in its industry. However, this method is only useful as a rough check, because companies do differ quite a bit within the same industry classification. As is clear from the image below, Cardno has a lower ROE than the average (16%) in the Construction industry.

ASX:CDD Past Revenue and Net Income, April 1st 2019
ASX:CDD Past Revenue and Net Income, April 1st 2019

Unfortunately, that's sub-optimal. We prefer it when the ROE of a company is above the industry average, but it's not the be-all and end-all if it is lower. Nonetheless, it might be wise to check if insiders have been selling.

The Importance Of Debt To Return On Equity

Companies usually need to invest money to grow their profits. That cash can come from issuing shares, retained earnings, or debt. 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. That will make the ROE look better than if no debt was used.

Combining Cardno's Debt And Its 2.9% Return On Equity

Although Cardno does use debt, its debt to equity ratio of 0.37 is still low. Its ROE is quite low, and the company already has some debt, so surely shareholders are hoping for an improvement. 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.

But It's Just One Metric

Return on equity is a useful indicator of the ability of a business to generate profits and return them to shareholders. A company that can achieve a high return on equity without debt could be considered a high quality business. 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.

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.

Of course, you might find a fantastic investment by looking elsewhere. So take a peek at this free list of interesting companies.

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.

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