Why Amcor plc (ASX: AMC) looks like a quality company
While some investors are already familiar with financial metrics (hat tip), this article is for those who want to learn more about return on equity (ROE) and why it matters. We will use ROE to examine Amcor plc (ASX: AMC), using a real world example.
ROE or Return on Equity is a useful tool to assess how effectively a company can generate returns on the investment it has received from its shareholders. In simpler terms, it measures a company’s profitability relative to equity.
Check out our latest review for Amcor
How is the ROE calculated?
the return on equity formula is:
Return on equity = Net income (from continuing operations) ÷ Equity
So, based on the above formula, Amcor’s ROE is:
18% = 869 million USD ÷ 4.7 billion USD (based on the last twelve months up to March 2021).
The “return” is the annual profit. This therefore means that for every Australian dollar invested by its shareholder, the company generates a profit of 0.18 Australian dollar.
Does Amcor have a good ROE?
An easy way to determine if a business is having a good return on equity is to compare it to the industry average. However, this method is only useful as a rough check, as companies differ a little within the same industry classification. Fortunately, Amcor has an above average ROE (9.6%) in the packaging industry.
This is what we love to see. However, keep in mind that a high ROE does not necessarily indicate efficient profit generation. A higher proportion of debt in a company’s capital structure can also result in high ROE, where high debt levels can represent a huge risk. Our risk dashboards must include the 2 risks that we have identified for Amcor.
How Does Debt Affect Return on Equity?
Almost all businesses need money to invest in the business, to increase their profits. The money to invest can come from the previous year’s profits (retained earnings), from issuing new shares, or from borrowing. In the first two cases, the ROE will capture this use of capital to grow. In the latter case, using debt will improve returns, but not change equity. In this way, the use of debt will increase the ROE, even if the basic economy of the business remains the same.
Amcor’s debt and its ROE of 18%
Noteworthy is Amcor’s high use of debt, leading to its debt-to-equity ratio of 1.39. There is no doubt that his ROE is decent, but the company’s very high debt is not too exciting to see. Investors should think carefully about a company’s performance if it couldn’t borrow so easily, as credit markets change over time.
Return on equity is one way we can compare the quality of business of different companies. In our books, the highest quality companies have a high return on equity, despite low leverage. If two companies have roughly the same level of debt to equity and one has a higher ROE, I generally prefer the one with a higher ROE.
But when a business is of high quality, the market often puts it at a price that reflects that. Especially important to consider are the growth rates of earnings, relative to expectations reflected in the share price. You might want to take a look at this data-rich interactive graph of business forecasting.
Of course, you might find a fantastic investment looking elsewhere. So take a look at this free list of interesting companies.
When trading Amcor or any other investment, use the platform seen by many as the trader’s gateway to the global market, Interactive Brokers. You get the cheapest * trading in stocks, options, futures, currencies, bonds and funds worldwide from a single integrated account.
This Simply Wall St article is general in nature. It does not constitute a recommendation to buy or sell any stock, and does not take into account your goals or your financial situation. We aim to bring you long-term, targeted analysis based on fundamental data. Note that our analysis may not take into account the latest announcements from price sensitive companies or qualitative information. Simply Wall St has no position in any of the stocks mentioned.
*Interactive Brokers Ranked Least Expensive Broker By StockBrokers.com Annual Online Review 2020
Do you have any comments on this article? Concerned about the content? Get in touch with us directly. Otherwise, email the editorial team (at) simplywallst.com.