Should Encavis AG (ETR:ECV) Focus On Improving This Fundamental Metric?

Simply Wall St · 09/15/2023 07:46

One of the best investments we can make is in our own knowledge and skill set. With that in mind, this article will work through how we can use Return On Equity (ROE) to better understand a business. We'll use ROE to examine Encavis AG (ETR:ECV), by way of a worked example.

Return on Equity or ROE is a test of how effectively a company is growing its value and managing investors’ money. Put another way, it reveals the company's success at turning shareholder investments into profits.

See our latest analysis for Encavis

How Is ROE Calculated?

ROE 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 Encavis is:

6.0% = €69m ÷ €1.2b (Based on the trailing twelve months to June 2023).

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 €0.06 in profit.

Does Encavis Have A Good ROE?

One simple way to determine if a company has a good return on equity is to compare it to the average for its industry. Importantly, this is far from a perfect measure, because companies differ significantly within the same industry classification. If you look at the image below, you can see Encavis has a lower ROE than the average (11%) in the Renewable Energy industry classification.

roe
XTRA:ECV Return on Equity September 15th 2023

Unfortunately, that's sub-optimal. That being said, a low ROE is not always a bad thing, especially if the company has low leverage as this still leaves room for improvement if the company were to take on more debt. A company with high debt levels and low ROE is a combination we like to avoid given the risk involved. You can see the 3 risks we have identified for Encavis by visiting our risks dashboard for free on our platform here.

Why You Should Consider Debt When Looking At ROE

Virtually all companies need money to invest in the business, to grow profits. That cash can come from issuing shares, retained earnings, or debt. In the first two cases, the ROE will capture this use of capital to grow. In the latter case, the use of debt will improve the returns, but will not change the equity. That will make the ROE look better than if no debt was used.

Encavis' Debt And Its 6.0% ROE

Encavis clearly uses a high amount of debt to boost returns, as it has a debt to equity ratio of 1.34. Its ROE is quite low, even with the use of significant debt; that's not a good result, in our opinion. Debt does bring extra risk, so it's only really worthwhile when a company generates some decent returns from it.

Conclusion

Return on equity is one way we can compare its business quality of different companies. A company that can achieve a high return on equity without debt could be considered a high quality business. All else being equal, a higher ROE is better.

Having said that, while ROE is a useful indicator of business quality, you'll have to look at a whole range of factors to determine the right price to buy a stock. It is important to consider other factors, such as future profit growth -- and how much investment is required going forward. So you might want to take a peek at this data-rich interactive graph of forecasts for the company.

Of course, you might find a fantastic investment by looking elsewhere. So take a peek at this free list of interesting companies.