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. As a learning by doing, we will look at the ROE to better understand Nagarro SE (FRA: NA9).
Return on equity or ROE is a key metric used to assess the efficiency with which the management of a business is using business capital. In other words, it reveals the company’s success in turning shareholders’ investments into profits.
See our latest analysis for Nagarro
How to calculate return on equity?
ROE can be calculated using the formula:
Return on equity = Net income (from continuing operations) Ã· Equity
So, based on the above formula, Nagarro’s ROE is:
31% = 23 million euros Ã· 72 million euros (based on the last twelve months up to June 2021).
The “return” is the income the business has earned over the past year. One way to conceptualize this is that for every â¬ 1 of share capital it has, the company has made â¬ 0.31 in profit.
Does Nagarro have a good ROE?
By comparing a company’s ROE with its industry average, we can get a quick measure of its quality. It is important to note that this measure is far from perfect, as companies differ considerably within a single industry classification. Fortunately, Nagarro has an above-average ROE (11%) for the IT industry.
This is what we love to see. That said, high ROE doesn’t always indicate high profitability. A higher proportion of debt in a company’s capital structure can also result in high ROE, where high debt levels could represent a huge risk. Our risk dashboard should contain the 4 risks we have identified for Nagarro.
What is the impact of debt on ROE?
Most businesses need money – from somewhere – to increase their profits. This liquidity can come from the issuance of shares, retained earnings or debt. In the first and second cases, the ROE will reflect this use of cash for investing in the business. In the latter case, the debt necessary for growth will increase returns, but will have no impact on equity. This will make the ROE better than if no debt was used.
Nagarro’s debt and its 31% ROE
Nagarro clearly uses a high amount of debt to increase returns, as he has a debt ratio of 2.50. There is no doubt that the ROE is impressive, but it should be borne in mind that the measurement could have been lower had the company reduced its debt. Leverage increases risk and reduces options for the business in the future, so you usually want to get good returns using 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. If two companies have the same ROE, then I would generally prefer the one with the least amount of debt.
But when a company is of high quality, the market often offers it up to a price that reflects that. 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 analyst forecast report for the company.
Sure, you might find a fantastic investment looking elsewhere. So take a look at this free list of interesting companies.
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