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. We’ll use ROE to examine Prosegur Compañía de Seguridad, S.A. (BME:PSG), by way of a worked example.
Return on Equity or ROE is a test of how effectively a company is growing its value and managing investors’ money. In other words, it is a profitability ratio which measures the rate of return on the capital provided by the company’s shareholders.
How Do You Calculate Return On Equity?
The formula for return on equity is:
Return on Equity = Net Profit (from continuing operations) ÷ Shareholders’ Equity
So, based on the above formula, the ROE for Prosegur Compañía de Seguridad is:
44% = €336m ÷ €758m (Based on the trailing twelve months to March 2021).
The ‘return’ is the income the business earned over the last year. So, this means that for every €1 of its shareholder’s investments, the company generates a profit of €0.44.
Does Prosegur Compañía de Seguridad 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 you can see in the graphic below, Prosegur Compañía de Seguridad has a higher ROE than the average (12%) in the Commercial Services industry.
That is a good sign. However, bear in mind that a high ROE doesn’t necessarily indicate efficient profit generation. Especially when a firm uses high levels of debt to finance its debt which may boost its ROE but the high leverage puts the company at risk. To know the 2 risks we have identified for Prosegur Compañía de Seguridad visit our risks dashboard for free.
How Does Debt Impact ROE?
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 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.
Prosegur Compañía de Seguridad’s Debt And Its 44% ROE
Prosegur Compañía de Seguridad clearly uses a high amount of debt to boost returns, as it has a debt to equity ratio of 2.40. There’s no doubt the ROE is impressive, but it’s worth keeping in mind that the metric could have been lower if the company were to reduce its debt. Debt increases risk and reduces options for the company in the future, so you generally want to see some good returns from using it.
Return on equity is a useful indicator of the ability of a business to generate profits and return them to shareholders. In our books, the highest quality companies have high return on equity, despite low debt. If two companies have around the same level of debt to equity, and one has a higher ROE, I’d generally prefer the one with higher ROE.
But ROE is just one piece of a bigger puzzle, since high quality businesses often trade on high multiples of earnings. The rate at which profits are likely to grow, relative to the expectations of profit growth reflected in the current price, must be considered, too. So I think it may be worth checking this free report on analyst forecasts for the company.
Of course Prosegur Compañía de Seguridad may not be the best stock to buy. So you may wish to see this free collection of other companies that have high ROE and low debt.
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