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Can Dana Incorporated's (NYSE:DAN) ROE Continue To Surpass The Industry Average?

Simply Wall St

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 Dana Incorporated (NYSE:DAN).

Dana has a ROE of 29%, based on the last twelve months. That means that for every $1 worth of shareholders' equity, it generated $0.29 in profit.

View our latest analysis for Dana

How Do You Calculate ROE?

The formula for ROE is:

Return on Equity = Net Profit ÷ Shareholders' Equity

Or for Dana:

29% = US$427m ÷ US$1.5b (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. Shareholders' equity can be calculated by subtracting the total liabilities of the company from the total assets of the company.

What Does ROE Signify?

ROE measures a company's profitability against the profit it retains, and any outside investments. The 'return' is the yearly profit. A higher profit will lead to a higher ROE. So, all else equal, investors should like a high ROE. That means it can be interesting to compare the ROE of different companies.

Does Dana 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. As you can see in the graphic below, Dana has a higher ROE than the average (18%) in the Auto Components industry.

NYSE:DAN Past Revenue and Net Income, April 10th 2019

That's what I like to see. 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 Return On Equity?

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 debt used for growth will improve returns, but won't affect the total equity. In this manner the use of debt will boost ROE, even though the core economics of the business stay the same.

Combining Dana's Debt And Its 29% Return On Equity

Dana clearly uses a significant amount of debt to boost returns, as it has a debt to equity ratio of 1.23. There's no doubt its ROE is impressive, but the company appears to use its debt to boost that metric. Debt does bring extra risk, so it's only really worthwhile when a company generates some decent returns from it.

The Key Takeaway

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. If two companies have the same ROE, then I would generally prefer the one with less debt.

But ROE is just one piece of a bigger puzzle, since high quality businesses often trade on high multiples of earnings. Profit growth rates, versus the expectations reflected in the price of the stock, are a particularly important to consider. So you might want to check this FREE visualization of analyst forecasts for the company.

If you would prefer check out another company -- one with potentially superior financials -- then do not miss this free list of interesting companies, that have HIGH return on equity 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.