Many investors are still learning the different metrics that can be helpful when analyzing a stock. This article is for those who want to know more about return on equity (ROE). We will use ROE to review Matrix IT Ltd. (TLV:MTRX), as a concrete example.
ROE or return on equity is a useful tool for evaluating how effectively a company can generate returns on the investment it has received from its shareholders. In short, ROE shows the profit that each dollar generates in relation to the investments of its shareholders.
Check out our latest analysis for Matrix IT
How is ROE calculated?
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 Matrix IT is:
25% = ₪219 million ÷ ₪861 million (based on the last twelve months to September 2021).
The “return” is the annual profit. This therefore means that for every ₪1 of its shareholder’s investment, the company generates a profit of 0.25 ₪.
Does Matrix IT have a good ROE?
A simple way to determine if a company has a good return on equity is to compare it to the average for its industry. However, this method is only useful as a rough check, as companies differ quite a bit within the same industry classification. The image below shows that Matrix IT has an ROE that is roughly in line with the IT industry average (21%).
It’s not surprising, but it’s respectable. Although the ROE is similar to that of the industry, we still need to perform further checks to see if the company’s ROE is being boosted by high debt levels. If true, this is more an indication of risk than potential. You can see the 2 risks we have identified for Matrix IT by visiting our risk dashboard for free on our platform here.
What is the impact of debt on ROE?
Companies generally need to invest money to increase their profits. This money 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 debt necessary for growth will boost returns, but will not impact shareholders’ equity. In this way, the use of debt will increase ROE, even though the core economics of the business remains the same.
Combine Matrix IT’s debt and its 25% return on equity
Matrix IT clearly uses a high amount of debt to increase returns, as its debt-to-equity ratio is 1.18. While there is no doubt that its ROE is impressive, we would have been even more impressed if the company had achieved this with less debt. Investors need to think carefully about how a company would 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 business 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 ROE is only one piece of a larger puzzle, as high-quality companies often trade on high earnings multiples. Earnings growth rates, relative to expectations reflected in the share price, are particularly important to consider. You can see how the company has grown in the past by watching this FREE detailed graph past profits, revenue and cash flow.
Sure Matrix IT may not be the best stock to buy. So you might want to see this free collection of other companies that have 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.