Should We Be Delighted With RATIONAL Aktiengesellschaft's (ETR:RAA) ROE Of 37%?
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. To keep the lesson grounded in practicality, we'll use ROE to better understand RATIONAL Aktiengesellschaft (ETR:RAA).
Over the last twelve months RATIONAL has recorded a ROE of 37%. That means that for every €1 worth of shareholders' equity, it generated €0.37 in profit.
Check out our latest analysis for RATIONAL
How Do You Calculate ROE?
The formula for ROE is:
Return on Equity = Net Profit (from continuing operations) ÷ Shareholders' Equity
Or for RATIONAL:
37% = €173m ÷ €471m (Based on the trailing twelve months to September 2019.)
Most readers would understand what net profit is, but it’s worth explaining the concept of shareholders’ equity. It is all earnings retained by the company, plus any capital paid in by shareholders. Shareholders' equity can be calculated by subtracting the total liabilities of the company from the total assets of the company.
What Does Return On Equity Signify?
ROE looks at the amount a company earns relative to the money it has kept within the business. The 'return' is the yearly profit. That means that the higher the ROE, the more profitable the company is. So, as a general rule, a high ROE is a good thing. Clearly, then, one can use ROE to compare different companies.
Does RATIONAL 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, RATIONAL has a better ROE than the average (11%) in the Machinery industry.
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.
The Importance Of Debt To Return On Equity
Most companies need money -- from somewhere -- to grow their profits. That cash can come from retained earnings, issuing new shares (equity), 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.
RATIONAL's Debt And Its 37% ROE
RATIONAL has a debt to equity ratio of just 0.02, which is very low. Its ROE is very impressive, and given only modest debt, this suggests the business is high quality. Conservative use of debt to boost returns is usually a good move for shareholders, though it does leave the company more exposed to interest rate rises.
In Summary
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. All else being equal, a higher ROE is better.
But when a business is high quality, the market often bids it up to a price that reflects this. It is important to consider other factors, such as future profit growth -- and how much investment is required going forward. So I think it may be worth checking this free report on analyst forecasts for the company.
But note: RATIONAL may not be the best stock to buy. So take a peek at this free list of interesting companies with high ROE and low debt.
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.
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