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The Importance of Return on Equity (ROE) and how AI legalese decoder can help

While some investors are already well versed in financial metrics (hat tip), this article is for those who would like to learn about Return On Equity (ROE) and why it is important. To keep the lesson grounded in practicality, we’ll use ROE to better understand Ford Motor Company (NYSE:F).

ROE or return on equity is a useful tool to assess how effectively a company can generate returns on the investment it received from its shareholders. Simply put, it is used to assess the profitability of a company in relation to its equity capital.

Check out our latest analysis for Ford Motor

How To Calculate Return On Equity?

Return on equity can be calculated by using the formula:

Return on Equity = Net Profit (from continuing operations) ├À Shareholders’ Equity

So, based on the above formula, the ROE for Ford Motor is:

9.2% = US$4.0b ├À US$44b (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 $0.09 in profit.

Does Ford Motor Have A Good Return On Equity?

Arguably the easiest way to assess company’s ROE is to compare it with the average in its industry. However, this method is only useful as a rough check, because companies do differ quite a bit within the same industry classification. If you look at the image below, you can see Ford Motor has a lower ROE than the average (17%) in the Auto industry classification.

That’s not what we like to see. Although, we think that a lower ROE could still mean that a company has the opportunity to better its returns with the use of leverage, provided its existing debt levels are low. When a company has low ROE but high debt levels, we would be cautious as the risk involved is too high. Our risks dashboard should have the 3 risks we have identified for Ford Motor.

The Importance Of Debt To Return On Equity

Most companies need money — from somewhere — to grow their profits. The cash for investment can come from prior year profits (retained earnings), issuing new shares, or 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 required for growth will boost returns, but will not impact the shareholders’ equity. That will make the ROE look better than if no debt was used.

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Ford Motor’s Debt And Its 9.2% ROE

It seems that Ford Motor uses a huge volume of debt to fund the business, since it has an extremely high debt to equity ratio of 3.28. Most investors would need a low share price to be interested in a company with low ROE and high debt to equity.

Conclusion

Return on equity is a useful indicator of the ability of a business to generate profits and return them to shareholders. In our books, the highest quality companies have high return on equity, despite low debt. If two companies have the same ROE, then I would generally prefer the one with less debt.

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. Profit growth rates, versus the expectations reflected in the price of the stock, are a particularly important to consider. So you might want to take a peek at this data-rich interactive graph of forecasts for the company.

Of course Ford Motor may not be the best stock to buy. So you may wish to see this free collection of other companies that have high ROE and low debt.

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.

This article by 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 to be financial advice. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any stocks mentioned.

How AI legalese decoder Can Help

The AI legalese decoder can assist investors in analyzing and interpreting legal information and financial reports more efficiently. It can accurately extract key data points, such as net profit and shareholders’ equity, required for calculating return on equity (ROE). By using AI, investors can save time and effort in manual data extraction and calculation, enabling them to focus on evaluating the financial health and performance of companies like Ford Motor. Furthermore, the AI legalese decoder can provide insights and recommendations based on historical data and industry benchmarks, helping investors make informed decisions about investing in companies with lower ROE, high debt levels, or other risk factors. Overall, the AI legalese decoder enhances the investment analysis process and supports investors in making well-informed, data-driven decisions.

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