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This article first appeared on Simply Wall St News.
Just days ago, the U.S. Senate passed the infrastructure bill, a fresh tailwind into the companies like Caterpillar Inc. (NYSE:CAT).
Q2 Earnings and Developments
Non-GAAP EPS: US$2.60 (beat by US$0.19)
GAAP EPS: US$2.56 (beat by US$0.27)
Revenue: US$12.9b (beat by US$370m)
Operating margin improved to 13.9% (from 7.8% in Q2 20)
Interestingly, Caterpillar is one of the two companies (along with Equitable Holdings(NYSE:EQH))that remain on Credit Suisse's recommended “Top of the Crop” list.
Caterpillar was one of the stocks that rallied after the senate passed the US$1.2t infrastructure bill. Given that around 40% of its revenue comes from the U.S, it is not surprising that the stock is currently 6.5% up from the lows.
Today, we will examine its Return on Equity (ROE) and the latest developments to gauge how well the largest maker of construction and mining equipment is prepared to benefit from such opportunities.
A shareholder's return on equity or ROE is an important factor to consider because it tells them how effectively their capital is being reinvested. Simply put, it is used to assess a company's profitability to its equity capital.
How To Calculate Return On Equity?
Return on Equity = Net Profit (from continuing operations) ÷ Shareholders' Equity
So, based on the above formula, the ROE for Caterpillar is:
26% = US$4.4b ÷ US$17b (Based on the trailing twelve months to June 2021).
The "return" is the amount earned after tax over the last twelve months. Another way to think of that is that for every $1 worth of equity, the company was able to earn $0.26 in profit.
Does Caterpillar Have A Good Return On Equity?
A 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 helpful as a rough check because companies differ quite a bit within the same industry classification. As you can see in the graphic below, Caterpillar has a higher ROE than the average (12%) in the Machinery industry.
That is a good sign. However, bear in mind that a high ROE doesn't necessarily indicate efficient profit generation. A higher proportion of debt in a company's capital structure may also result in a high ROE, where the high debt levels could be a considerable risk.
The Importance Of Debt To Return On Equity
Most companies need 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 debt used for growth will improve returns but won't affect the total equity. Thus the use of debt can improve ROE, albeit along with extra risk in the case of stormy weather, metaphorically speaking.
Combining Caterpillar's Debt And Its 26% Return On Equity
Caterpillar does use a high amount of debt to increase returns. It has a debt-to-equity ratio of 2.18. There's no doubt the ROE is impressive, but it's worth considering that the metric could have been lower if the company were to reduce its debt.
Debt does bring additional risk, so it's only really worthwhile when a company generates decent returns.
Return on equity is useful for comparing the quality of different businesses. A company that can achieve a high return on equity without debt could be considered a high-quality business.
Overall, it seems that Caterpillar is well-positioned to take advantage of the upcoming infrastructure bill. Even if it takes a while for those earnings to show in reports, the investors will wait while collecting a stable and solid 2% dividend.
While ROE is a helpful indicator of business quality, you'll have to look at a whole range of factors to determine the right price to buy a stock. It is important to consider other factors, such as future profit growth and how much investment is required going forward. 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 look at this free list of interesting companies.
Simply Wall St analyst Stjepan Kalinic and Simply Wall St have no position in any of the companies mentioned. This article is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. It does not constitute a recommendation to buy or sell any stock and does not take account of your objectives, or your financial situation. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material.