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. We’ll use ROE to examine Corporate Office Properties Trust (NYSE: OFC), by way of a worked example.
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. In simpler terms, it measures the profitability of a company in relation to shareholder’s equity.
Check out our latest analysis for Corporate Office Properties Trust
How Do You Calculate Return On Equity?
Return on equity 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 Corporate Office Properties Trust is:
6.8% = US $ 116m ÷ US $ 1.7b (Based on the trailing twelve months to March 2022).
The ‘return’ is the income the business earned over the last year. So, this means that for every $ 1 of its shareholder’s investments, the company generates a profit of $ 0.07.
Does Corporate Office Properties Trust Have A Good ROE?
By comparing a company’s ROE with its industry average, we can get a quick measure of how good it is. The limitation of this approach is that some companies are quite different from others, even within the same industry classification. If you look at the image below, you can see Corporate Office Properties Trust has a similar ROE to the average in the REITs industry classification (6.5%).
So while the ROE is not exceptional, at least its acceptable. Even if the ROE is respectable when compared to the industry, its worth checking if the firm’s ROE is being aided by high debt levels. If true, then it is more an indication of risk than the potential. You can see the 2 risks we have identified for Corporate Office Properties Trust by visiting our risks dashboard for free on our platform here.
How Does Debt Impact Return On Equity?
Most companies need money – from somewhere – to grow their 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 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.
Combining Corporate Office Properties Trust’s Debt And Its 6.8% Return On Equity
Corporate Office Properties Trust clearly uses a high amount of debt to boost returns, as it has a debt to equity ratio of 1.26. The combination of a rather low ROE and significant use of debt is not particularly appealing. Investors should think carefully about how a company might perform if it was unable to borrow so easily, because credit markets do change over time.
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. 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. The rate at which profits are likely to grow, relative to the expectations of profit growth reflected in the current price, must be considered, too. So I think it may be worth checking this out free report on analyst forecasts for the company.
If you would rather check out another company – one with potentially superior financials – then don’t miss this free list of interesting companies, that have HIGH return on equity and low debt.
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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 into account 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.