Many investors are still learning the different metrics that can be useful when analyzing a stock. This article is for those who want to know more about return on equity (ROE). We will use ROE to examine Saudi Real Estate Company (TADAWUL:4020), as a concrete example.
Return on equity or ROE is a key metric used to gauge how effectively a company’s management is using the company’s capital. In short, ROE shows the profit that each dollar generates in relation to the investments of its shareholders.
See our latest analysis of Saudi real estate
How to calculate return on equity?
ROE can be calculated using the formula:
Return on equity = Net income (from continuing operations) ÷ Equity
So, based on the above formula, the ROE for Saudi real estate is:
2.7% = ر.س81m ÷ ر.س3.0b (Based on the last twelve months to December 2021).
The “return” is the annual profit. One way to conceptualize this is that for every SAR1 of share capital it has, the company has made a profit of 0.03 SAR.
Does Saudi real estate have a good return on equity?
Perhaps the easiest way to assess a company’s ROE is to compare it to the industry average. The limitation of this approach is that some companies are very different from others, even within the same industrial classification. As the image below clearly shows, Saudi real estate has a lower ROE than the average (6.1%) for the real estate sector.
It’s certainly not ideal. However, we believe that a lower ROE could still mean that a company has the opportunity to improve its returns through the use of leverage, provided its existing debt levels are low. A company with high debt levels and low ROE is a combination we like to avoid given the risk involved.
What is the impact of debt on return on equity?
Companies generally need to invest money to increase their profits. The money for the investment can come from the previous year’s earnings (retained earnings), from issuing new shares or from 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 necessary for growth will boost returns, but will not impact equity. So using debt can improve ROE, but with the added risk of stormy weather, metaphorically speaking.
Saudi real estate debt and its ROE of 2.7%
Of note is the heavy use of debt by Saudi Real Estate, leading to its debt-to-equity ratio of 1.31. The combination of a rather low ROE and heavy reliance on debt is not particularly attractive. Debt brings additional risk, so it’s only really worth it when a business is generating decent returns.
Return on equity is useful for comparing the quality of different companies. A company that can earn a high return on equity without going into debt could be considered a high quality company. If two companies have the same ROE, I would generally prefer the one with less debt.
But when a company is of high quality, the market often gives it a price that reflects that. Earnings growth rates, relative to expectations reflected in the share price, are particularly important to consider. So I think it’s worth checking it out free this detailed graph past profits, revenue and cash flow.
But note: Saudi real estate may not be the best stock to buy. So take a look at this free list of interesting companies with high ROE and low debt.
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This Simply Wall St article is general in nature. We provide commentary based on historical data and analyst forecasts only using unbiased methodology and our articles are not intended to be financial advice. It is not a recommendation to buy or sell stocks and does not take into account your objectives or financial situation. Our goal is to bring you targeted long-term analysis based on fundamental data. Note that our analysis may not take into account the latest announcements from price-sensitive companies or qualitative materials. Simply Wall St has no position in the stocks mentioned.