One of the best investments we can make is in our own knowledge and skills. With that in mind, this article will explain how we can use Return On Equity (ROE) to better understand a company. We use ROE to represent Global Ship Lease, Inc. to investigate (NYSE:GSL), based on a worked example.
Return on Equity or ROE is an important factor that a shareholder should consider as it tells them how effectively their capital is being reinvested. In other words, it reveals the company’s success in turning shareholder investment into profit.
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Check out our latest analysis for Global Ship Lease
How is ROE calculated?
Return on equity can be calculated using the formula:
Return on equity = net profit (from continuing operations) ÷ equity
So, based on the above formula, the ROE for Global Ship Lease is:
11% = US$64 million ÷ US$593 million (based on 12 months remaining to June 2021).
The ‘return’ is the profit over the past twelve months. That means that for every $1 in equity, the company generated $0.11 in profit.
Does Global Ship Lease have a good return on equity?
By comparing a company’s ROE to the industry average, we can quickly see how good it is. However, this method is only useful as a rough check, as companies vary quite a bit within the same industry classification. You can see in the chart below that Global Ship Lease has an ROE that is pretty close to the average for the shipping industry (11%).
So while the ROE is not exceptional, it is at least acceptable. In any case, while the ROE is not lower than the industry, it is worth considering the role of corporate debt, as high levels of debt relative to equity can also make the ROE appear high. If so, it increases exposure to financial risk. You can review the 3 risks we have identified for Global Ship Lease by visiting our: risk dashboard for free on our platform here.
Why you should consider debt when looking at ROE?
Almost all businesses need money to invest in the business, to make a profit. That money can come from retained earnings, the issuance of new shares (equity) or debt. In the first and second case, the ROE will reflect this use of cash for investments in the company. In the latter case, the debt needed for growth will increase returns, but not affect equity. In this way, the use of debt will boost ROE even though the core economy of the company remains the same.
Global Ship Lease’s Debt and 11% ROE
Global Ship Lease is clearly using a high amount of debt to increase returns as it has a debt to equity ratio of 1.38. The ROE is quite low even with the use of significant debt; we don’t think that’s a good result. Debt does come with extra risk, so it’s only really worth it if a company gets a decent return from it.
Return on equity is useful for comparing the quality of different companies. Companies that can achieve a high return on equity without too much debt are generally of good quality. If two companies have about the same level of debt as equity, and one has a higher ROE, I would generally prefer the one with a higher ROE.
That said, while ROE is a useful indicator of business quality, you need to look at a whole host of factors to determine the right price to buy a stock. It is important to consider other factors, such as future earnings growth – and how much investment will be needed in the future. So you might want to take a look here data-rich interactive chart of business forecasts.
If you’d rather visit another company – one with potentially superior financial data – don’t miss this one free list of interesting companies with a HIGH return on equity and a low debt.
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This article from Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended as financial advice. It is not a recommendation to buy or sell stocks and does not take into account your objectives or your financial situation. We strive to provide you with long-term focused analysis powered by fundamental data. Please note that our analysis may not take into account the latest price-sensitive company announcements or quality material. Simply Wall St has no position in said stocks.
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