While some investors are already familiar with financial metrics (hat tip), this article is for those who want to learn more about return on equity (ROE) and why it is important. We will use the ROE to review Optibase Ltd. (NASDAQ: OBAS), using a concrete example.
Return on equity or ROE is an important factor for a shareholder to consider because it tells them how efficiently their capital is being reinvested. In simpler terms, it measures a company’s profitability relative to equity.
Check out our latest review for Optibase
How is the ROE calculated?
The return on equity formula is:
Return on equity = Net income (from continuing operations) ÷ Equity
So, based on the above formula, the ROE for Optibase is:
7.2% = US $ 6.1 million ÷ US $ 84 million (based on the last twelve months to June 2021).
The “return” is the profit of the last twelve months. Another way of thinking is that for every dollar in equity, the company was able to make $ 0.07 in profit.
Does Optibase have a good ROE?
By comparing a company’s ROE with its industry average, we can get a quick measure of its quality. However, this method is only useful as a rough check, as companies differ a lot within a single industry classification. You can see in the graph below that Optibase has an ROE quite close to the real estate industry average (7.8%).
So even if the ROE is not exceptional, it is at least acceptable. Even though the ROE is respectable compared to the industry, it is worth checking out if the company’s ROE is helped by high debt levels. If so, it increases their exposure to financial risk. To know the 3 risks that we have identified for Optibase, visit our risk dashboard free of charge.
The importance of debt to return on equity
Businesses generally need to invest money to increase their profits. This liquidity can come from the issuance of shares, retained earnings or debt. 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 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.
Optibase’s debt and its ROE of 7.2%
Optibase uses a high amount of debt to increase returns. Its debt to equity ratio is 1.33. The combination of a rather low ROE and a high recourse to debt is not particularly attractive. Investors should think carefully about how a business will perform if it weren’t able to borrow so easily, as credit markets change over time.
Return on equity is a way to compare the quality of the business of different companies. Firms that can earn high returns on equity without taking on too much debt are generally of good quality. All other things being equal, a higher ROE is better.
But when a company is of high quality, the market often offers it up to a price that reflects that. It is important to take into account other factors, such as future profit growth and the amount of investment required for the future. Check out Optibase’s past earnings growth by viewing this visualization of past earnings, revenue, and cash flow.
Sure Optibase may not be the best stock to buy. So you might want to see this free collection of other companies with high ROE and low leverage.
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This Simply Wall St article is general in nature. We provide commentary based on historical data and analyst forecasts using only unbiased methodology and our articles are not intended to be financial advice. It does not constitute a recommendation to buy or sell shares and does not take into account your goals or your financial situation. Our aim is to bring you long-term, targeted analysis based on fundamental data. Note that our analysis may not take into account the latest announcements from price sensitive companies or qualitative documents. Simply Wall St has no position in any of the stocks mentioned.
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