While some investors are already familiar with financial metrics (hat tip), this article is for those who want to learn about return on equity (ROE) and its importance. To keep the lesson grounded in practice, we'll use ROE to better understand Wolters Kluwer NV (AMS:WKL).
Return on equity or ROE tests how effectively a company is growing its value and managing investors' money. Simply put, it is used to evaluate a company's profitability compared to its equity.
Check out our latest analysis for Wolters Kluwer.
How do I calculate return on equity?
Return on equity can be calculated using the following formula:
Return on equity = Net income (from continuing operations) ÷ Shareholders' equity
So, based on the above formula, Wolters Kluwer's ROE is:
58% = €1 billion ÷ €1.7 billion (based on the trailing 12 months to December 2023).
“Return” refers to a company's earnings over the past year. One way he conceptualizes this is that for every €1 of shareholders' equity, the company made his €0.58 in profit.
Does Wolters Kluwer have a high return on equity?
By comparing a company's ROE with the industry average, you can easily measure how well a company performs. However, this method is only useful as a cursory check, as there is considerable variation between companies within the same industry classification. Pleasingly, Wolters Kluwer's ROE is better than the average (15%) in the Professional Services industry.
That's a good sign. However, keep in mind that a high ROE does not necessarily mean efficient profit generation. The higher the proportion of debt in a company's capital structure, the higher its ROE can be, and high debt levels can pose a major risk.
How does debt affect return on equity?
Businesses usually need to invest money to increase their profits. Cash for investments can come from previous years' profits (retained earnings), issuing new shares, or borrowings. For the first and second options, ROE reflects the use of cash for growth. In the latter case, using debt increases returns but does not change equity. If we do that, our ROE will be better than if we didn't take out debt.
Wolters Kluwer combines debt with a return on equity of 58%.
Wolters Kluwer's heavy use of debt is notable, giving it a debt-to-equity ratio of 1.99. There's no doubt that ROE is good, but it's worth bearing in mind that this metric could have been lower if the company had reduced its debt. Debt increases risk and limits a company's options in the future, so you usually want to get some return from using debt.
summary
Return on equity is a useful indicator of a company's ability to generate profits and return them to shareholders. A company that can achieve a high return on equity without debt can be said to be a high-quality company. All else being equal, a higher ROE is better.
However, if the quality of your business is high, the market will often bid up to a price that reflects that. It is important to consider other factors such as future profit growth and how much investment is required in the future. So you might want to take a peek at this data-rich, interactive graph depicting forecasts for this company.
of course Wolters Kluwer may not be the best stock to buy.So you might want to see this free A collection of other companies with high ROE and low debt.
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This article by Simply Wall St is general in nature. We provide commentary using only unbiased methodologies, based on historical data and analyst forecasts, and articles are not intended to be financial advice. This is not a recommendation to buy or sell any stock, and does not take into account your objectives or financial situation. We aim to provide long-term, focused analysis based on fundamental data. Note that our analysis may not factor in the latest announcements or qualitative material from price-sensitive companies. Simply Wall St has no position in any stocks mentioned.
