Many investors are still learning about the various metrics that can be useful when analyzing a stock. This article is intended for those who want to learn more about return on equity (ROE). Through learning-by-doing, we will look at ROE to gain a better understanding of Facilities by ADF plc (LON:ADF).
Return on Equity, or ROE, is a key metric used to assess how efficiently a company’s management is using the company’s capital. In short, ROE shows the profit each dollar generates in relation to its shareholders’ investments.
Try this chances and risks within the UK transport industry.
How do you calculate return on equity?
That Formula for ROE is:
Return on Equity = Net Income (from continuing operations) ÷ Equity
So, based on the formula above, the ROE for facilities of ADF is:
1.1% = £220,000 ÷ £20 million (based on trailing 12 months to June 2022).
The “return” is the annual profit. One way to conceptualize this is that the company makes a profit of £0.01 for every £1 of shareholder capital it has.
Does Facilities by ADF have a good ROE?
A simple way to tell if a company has a good return on equity is to compare it to the industry average. The limitation of this approach is that some companies differ greatly from others, even within the same industry classification. If you look at the image below, you can see that Facilities by ADF has a lower ROE than the average (21%) in the transportation industry classification.
That’s definitely not ideal. However, a low ROE is not always bad. If the company’s debt is moderate to low, there’s still a chance the return can be improved through the use of financial leverage. If a company has low ROE but high debt, we would be cautious as the risk involved is too high. Our risk dashboard should contain the 4 risks we have identified for ADF facilities.
Why you should think about debt when looking at ROE
Businesses usually need to invest money to increase their profits. The money for investments can come from the previous year’s earnings (retained earnings), issuing new shares or taking out loans. In the first and second cases, the ROE reflects this use of cash to invest in the company. In the latter case, the debt needed for growth will boost returns but not weigh on equity. Therefore, the use of leverage can improve ROE, albeit figuratively with additional risk in stormy weather.
Combining facilities through ADF’s debt and its 1.1% return on equity
Although Facilities by ADF uses little leverage, its gearing ratio is very low at just 0.014. Its ROE is fairly low and it uses some debt, although not much. That’s not great to see. Conservative use of leverage to boost yields is usually a good move for shareholders, although it does leave the company more exposed to interest rate hikes.
Return on equity is a useful indicator of a company’s ability to generate profits and return them to shareholders. Companies that can generate high returns on equity without over-leveraging are generally of good quality. In general, if two companies have roughly the same leverage and one has a higher ROE, I would prefer the one with the higher ROE.
But ROE is just one piece of a larger puzzle, as high-quality companies often trade at high profit multiples. Earnings growth rates versus expectations reflected in the stock price are particularly important to consider. So you might want to check out this FREE visualization of analyst forecasts for the company.
If you’d rather look at another company — one with potentially superior financials — then don’t miss it free List of interesting companies with HIGH return on equity and low debt.
The assessment is complex, but we help to simplify it.
find out if facilities of ADF may be over or under priced by reviewing our comprehensive analysis which includes the following Fair Value Estimates, Risks and Warnings, Dividends, Insider Trading and Financial Health.
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