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. To keep the lesson grounded in practicality, we’ll use ROE to better understand Nagarro SE (FRA:NA9).
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. Simply put, it is used to assess the profitability of a company in relation to its equity capital.
See our latest analysis for Nagarro
Return on equity can be calculated by using the formula:
Return on Equity = Net Profit (from continuing operations) ÷ Shareholders’ Equity
So, based on the above formula, the ROE for Nagarro is:
26% = €54m ÷ €204m (Based on the trailing twelve months to March 2024).
The ‘return’ is the amount earned after tax over the last twelve months. That means that for every €1 worth of shareholders’ equity, the company generated €0.26 in profit.
Arguably the easiest way to assess company’s ROE is to compare it with the average in its industry. The limitation of this approach is that some companies are quite different from others, even within the same industry classification. Pleasingly, Nagarro has a superior ROE than the average (11%) in the IT industry.
That is a good sign. With that said, a high ROE doesn’t always indicate high profitability. 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. Our risks dashboardshould have the 2 risks we have identified for Nagarro.
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 case of the first and second options, the ROE will reflect this use of cash, for growth. In the latter case, the debt used for growth will improve returns, but won’t affect the total equity. In this manner the use of debt will boost ROE, even though the core economics of the business stay the same.
Nagarro does use a high amount of debt to increase returns. It has a debt to equity ratio of 1.34. 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 does bring extra risk, so it’s only really worthwhile when a company generates some decent returns from it.
Return on equity is one way we can compare its business quality of different companies. Companies that can achieve high returns on equity without too much debt are generally of good quality. If two companies have the same ROE, then I would generally prefer the one with less debt.
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 you might want to check this FREE visualization of analyst forecasts for the company.
But note: Nagarro may not be the best stock to buy. So take a peek at this free list of interesting companies with high ROE and low debt.