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Should We Be Delighted With Knorr-Bremse Aktiengesellschaft’s (ETR:KBX) ROE Of 47%?

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. By way of learning-by-doing, we’ll look at ROE to gain a better understanding Knorr-Bremse Aktiengesellschaft (ETR:KBX).

Over the last twelve months Knorr-Bremse has recorded a ROE of 47%. One way to conceptualize this, is that for each €1 of shareholders’ equity it has, the company made €0.47 in profit.

Check out our latest analysis for Knorr-Bremse

How Do I Calculate ROE?

The formula for return on equity is:

Return on Equity = Net Profit ÷ Shareholders’ Equity

Or for Knorr-Bremse:

47% = 773.181 ÷ €1.5b (Based on the trailing twelve months to September 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. The easiest way to calculate shareholders’ equity is to subtract the company’s total liabilities from the 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 amount earned after tax over the last twelve months. The higher the ROE, the more profit the company is making. So, as a general rule, a high ROE is a good thing. That means ROE can be used to compare two businesses.

Does Knorr-Bremse 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. 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, Knorr-Bremse has a better ROE than the average (14%) in the machinery industry.

XTRA:KBX Last Perf December 4th 18
XTRA:KBX Last Perf December 4th 18

That’s clearly a positive. I usually take a closer look when a company has a better ROE than industry peers. For example you might check if insiders are buying shares.

How Does Debt Impact ROE?

Companies usually need to invest money to grow their profits. That cash can come from issuing shares, retained earnings, or debt. In the case of the first and second options, the ROE will reflect this use of cash, for growth. 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.

Knorr-Bremse’s Debt And Its 47% ROE

It’s worth noting the significant use of debt by Knorr-Bremse, leading to its debt to equity ratio of 1.04. There’s no doubt its ROE is impressive, but the company appears to use its debt to boost that metric. Investors should think carefully about how a company might perform if it was unable to borrow so easily, because credit markets do change over time.

But It’s Just One Metric

Return on equity is one way we can compare the business quality of different companies. In my book the highest quality companies have high return on equity, despite low debt. If two companies have the same ROE, then I would generally prefer the one with less debt.

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 check this FREE visualization of analyst 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.

To help readers see past the short term volatility of the financial market, we aim to bring you a long-term focused research analysis purely driven by fundamental data. Note that our analysis does not factor in the latest price-sensitive company announcements.

The author is an independent contributor and at the time of publication had no position in the stocks mentioned. For errors that warrant correction please contact the editor at editorial-team@simplywallst.com.