One of the best investments we can make is in our own knowledge and skills. With that in mind, this article will discuss how we can use Return on Equity (ROE) to better understand a business. To keep the lesson grounded in practice, we will use ROE to better understand Environmental Control Center Co., Ltd. (TYO: 4657).
Return on equity or ROE is an important factor for a shareholder to consider because it tells them how effectively their capital is being reinvested. Simply put, it is used to assess a company’s profitability against its equity.
See our latest review for Environmental Control Center Ltd
How to calculate return on equity?
The formula for ROE is:
Return on equity = Net income (from continuing operations) ÷ Equity
So, based on the above formula, the ROE for Environmental Control Center Ltd is:
12% = JP ¥ 214m JP ¥ 1.8b (Based on the last twelve months up to December 2020).
The “return” is the profit of the last twelve months. This means that for every 1 of equity, the company generated ¥ 0.12 in profit.
Does Environmental Control CenterLtd have a good return on equity?
A simple way to determine if a company has a good return on equity is to compare it to the average in its industry. However, this method is only useful as a rough check, as companies differ a lot within a single industry classification. As shown in the image below, Environmental Control CenterLtd has a better ROE than the commercial services industry average (7.5%).
It’s a good sign. However, keep in mind that a high ROE does not necessarily indicate efficient profit generation. Especially when a business uses high levels of leverage to finance its debt, which can increase its ROE, but high leverage puts the business at risk. You can see the 4 risks we have identified for Environmental Control Center Ltd by visiting our risk dashboard for free on our platform here.
What is the impact of debt on ROE?
Almost all businesses need money to invest in the business, to increase their profits. The money for the investment can come from the profits of the previous year (retained earnings), from the issuance of new shares or from loans. In the first two cases, the ROE will capture this use of capital to grow. In the latter case, the use of debt will improve returns, but will not affect equity. So, using debt can improve ROE, but with added risk in stormy weather, metaphorically speaking.
Combine Environmental Control CenterLtd’s debt and its 12% return on equity
Environmental Control CenterLtd clearly uses a high amount of debt to increase returns, as it has a debt ratio of 1.05. While its ROE is respectable, it should be borne in mind that there is usually a limit on how much debt a business can use. Debt comes with additional risk, so it’s only really worth it when a business is making decent returns from it.
Return on equity is a way to compare the quality of the business of different companies. A business that can earn a high return on equity without going into debt could be considered a high quality business. All other things being equal, a higher ROE is better.
That said, while ROE is a useful indicator of how good a business is, you’ll need to look at a whole range of factors to determine the right price to buy a stock. Especially important to consider are the growth rates of earnings, relative to expectations reflected in the share price. So I think it’s worth checking this out free this detailed graphic past profits, income and cash flow.
Sure Environmental Control CenterLtd May Not Be The Best Stock To Buy. So you might want to see this free collection of other companies with high ROE and low leverage.
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This Simply Wall St article is general in nature. It does not constitute a recommendation to buy or sell shares and does not take into account your goals or your financial situation. Our aim is to bring you long-term, targeted analysis based on fundamental data. Note that our analysis may not take into account the latest announcements from price sensitive companies or qualitative documents. Simply Wall St has no position in any of the stocks mentioned.
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