While some investors are already well versed in financial metrics (hat tip), this article is for those who would like to learn about Return On Equity (ROE) and why it is important. By way of learning-by-doing, we'll look at ROE to gain a better understanding of Dampskibsselskabet Norden A/S (CPH:DNORD).
Over the last twelve months Dampskibsselskabet Norden has recorded a ROE of 0.7%. One way to conceptualize this, is that for each DKK1 of shareholders' equity it has, the company made DKK0.01 in profit.
How Do You Calculate ROE?
The formula for return on equity is:
Return on Equity = Net Profit ÷ Shareholders' Equity
Or for Dampskibsselskabet Norden:
0.7% = US$6.1m ÷ US$819m (Based on the trailing twelve months to September 2019.)
It's easy to understand the 'net profit' part of that equation, but 'shareholders' equity' requires further explanation. It is the capital paid in by shareholders, plus any retained earnings. You can calculate shareholders' equity by subtracting the company's total liabilities from its total assets.
What Does ROE Signify?
ROE measures a company's profitability against the profit it retains, and any outside investments. 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 Dampskibsselskabet Norden Have A Good Return On Equity?
One simple way to determine if a company has a good return on equity is to compare it to the average for its industry. The limitation of this approach is that some companies are quite different from others, even within the same industry classification. If you look at the image below, you can see Dampskibsselskabet Norden has a lower ROE than the average (6.8%) in the Shipping industry classification.
Unfortunately, that's sub-optimal. It is better when the ROE is above industry average, but a low one doesn't necessarily mean the business is overpriced. Nonetheless, it could be useful to double-check if insiders have sold shares recently.
How Does Debt Impact Return On Equity?
Virtually all companies need money to invest in the business, to grow profits. That cash can come from issuing shares, retained earnings, or debt. In the first two cases, the ROE will capture this use of capital to grow. In the latter case, the debt required for growth will boost returns, but will not impact the shareholders' equity. That will make the ROE look better than if no debt was used.
Dampskibsselskabet Norden's Debt And Its 0.7% ROE
While Dampskibsselskabet Norden does have some debt, with debt to equity of just 0.39, we wouldn't say debt is excessive. Its ROE is certainly on the low side, and since it already uses debt, we're not too excited about the company. 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 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. All else being equal, a higher ROE is better.
But ROE is just one piece of a bigger puzzle, since high quality businesses often trade on high multiples of earnings. The rate at which profits are likely to grow, relative to the expectations of profit growth reflected in the current price, must be considered, too. So I think it may be worth checking this free report on analyst forecasts for the company.
Of course Dampskibsselskabet Norden 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.
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