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 Exchange Income Corporation (TSE:EIF).
Return on equity or ROE is an important factor to be considered by a shareholder because it tells them how effectively their capital is being reinvested. 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 Exchange Income is:
7.3% = CA$52m ÷ CA$709m (Based on the trailing twelve months to June 2020).
The ‘return’ refers to a company’s earnings over the last year. So, this means that for every CA$1 of its shareholder’s investments, the company generates a profit of CA$0.07.
Does Exchange Income Have A Good Return On Equity?
By comparing a company’s ROE with its industry average, we can get a quick measure of how good it is. The limitation of this approach is that some companies are quite different from others, even within the same industry classification. If you look at the image below, you can see Exchange Income has a similar ROE to the average in the Airlines industry classification (7.3%).
That isn’t amazing, but it is respectable. While at least the ROE is not lower than the industry, its still worth checking what role the company’s debt plays as high debt levels relative to equity may also make the ROE appear high. If so, this increases its exposure to financial risk. Our risks dashboardshould have the 3 risks we have identified for Exchange Income.
How Does Debt Impact Return On Equity?
Virtually all companies need money to invest in the business, to grow profits. The cash for investment can come from prior year profits (retained earnings), issuing new shares, or borrowing. 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 the returns, but will not change the equity. That will make the ROE look better than if no debt was used.
Exchange Income’s Debt And Its 7.3% ROE
Exchange Income does use a high amount of debt to increase returns. It has a debt to equity ratio of 1.58. Its ROE is quite low, even with the use of significant debt; that’s not a good result, in our opinion. 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.
Return on equity is one way we can compare its business quality of different companies. A company that can achieve a high return on equity without debt…
Go to the news source: Exchange Income Corporation (TSE:EIF) Has A ROE Of 7.3%