Many investors are still learning about the various metrics that can be useful when analysing a stock. This article is for those who would like to learn about Return On Equity (ROE). To keep the lesson grounded in practicality, we’ll use ROE to better understand Pfeiffer Vacuum Technology AG (FRA:PFV).
Our data shows Pfeiffer Vacuum Technology has a return on equity of 19% for the last year. Another way to think of that is that for every €1 worth of equity in the company, it was able to earn €0.19.
How Do I Calculate ROE?
The formula for ROE is:
Return on Equity = Net Profit ÷ Shareholders’ Equity
Or for Pfeiffer Vacuum Technology:
19% = €64m ÷ €338m (Based on the trailing twelve months to June 2018.)
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. The easiest way to calculate shareholders’ equity is to subtract the company’s total liabilities from the total assets.
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. A higher profit will lead to a higher ROE. So, all else being equal, a high ROE is better than a low one. Clearly, then, one can use ROE to compare different companies.
Does Pfeiffer Vacuum Technology Have A Good ROE?
Arguably the easiest way to assess company’s ROE is to compare it with the average in its industry. Importantly, this is far from a perfect measure, because companies differ significantly within the same industry classification. As you can see in the graphic below, Pfeiffer Vacuum Technology has a higher ROE than the average (13%) in the machinery industry.
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?
Most companies need money — from somewhere — 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 use of debt will improve the returns, but will not change the equity. That will make the ROE look better than if no debt was used.
Combining Pfeiffer Vacuum Technology’s Debt And Its 19% Return On Equity
While Pfeiffer Vacuum Technology does have some debt, with debt to equity of just 0.18, we wouldn’t say debt is excessive. The fact that it achieved a fairly good ROE with only modest debt suggests the business might be worth putting on your watchlist. 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.
The Bottom Line On ROE
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. 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. Profit growth rates, versus the expectations reflected in the price of the stock, are a particularly important to consider. So I think it may be worth checking this free report on 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 firstname.lastname@example.org.