Is MDI Energia SA (WSE: MDI) high quality stock to own?

One of the best investments we can make is in our own knowledge and skills. With that in mind, this article will discuss how we can use Return on Equity (ROE) to better understand a business. We will use ROE to examine MDI Energia SA (WSE: MDI), through a worked example.

Return on equity or ROE is an important factor for a shareholder to consider because it tells them how effectively their capital is being reinvested. In simpler terms, it measures a company’s profitability relative to equity.

See our latest review for MDI Energia

How do you calculate return on equity?

ROE can be calculated using the formula:

Return on equity = Net income (from continuing operations) ÷ Equity

So, based on the above formula, the ROE of MDI Energia is:

20% = zł6,7m zł34m (Based on the last twelve months up to September 2021).

The “return” is the annual profit. This means that for every PLN 1 value of equity, the company generated a profit of PLN 0.20.

Does MDI Energia have a good return on equity?

By comparing a company’s ROE with its industry average, we can get a quick measure of its quality. It is important to note that this measure is far from perfect, as companies differ considerably within a single industry classification. Fortunately, MDI Energia has an above-average ROE (9.5%) for the renewable energy sector.

WSE: MDI Return on Equity November 26, 2021

This is what we love to see. That said, high ROE doesn’t always indicate high profitability. Besides changes in net income, high ROE can also be the result of high leverage to equity, which indicates risk. Our risk dashboard should include the 3 risks that we have identified for MDI Energia.

Why You Should Consider Debt When Looking At ROE

Businesses generally need to invest money to increase their profits. This liquidity can come from the issuance of shares, retained earnings or debt. 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 necessary for growth will increase returns, but will have no impact on equity. So, using debt can improve ROE, but with added risk in stormy weather, metaphorically speaking.

Combine MDI Energia’s debt and its 20% return on equity

MDI Energia uses a large amount of debt to increase returns. Its debt ratio is 1.69. While its ROE is respectable, it should be borne in mind that there is usually a limit on how much debt a business can use. Investors should think carefully about how a business will perform if it weren’t able to borrow so easily, as credit markets change over time.

Conclusion

Return on equity is a way to compare the business quality of different companies. In our books, the highest quality companies have a high return on equity, despite low leverage. If two companies have the same ROE, I would generally prefer the one with the least amount of debt.

But when a company is of high quality, the market often offers it up to a price that reflects that. The rate at which earnings are likely to grow, relative to earnings growth expectations reflected in the current price, must also be considered. Check out MDI Energia’s past earnings growth by looking at this visualization of past earnings, revenue, and cash flow.

Sure MDI Energia may not be the best stock to buy. So you might want to see this free collection of other companies with high ROE and low leverage.

This Simply Wall St article is general in nature. We provide commentary based on historical data and analyst forecasts using only unbiased methodology and our articles are not intended to be financial advice. It does not constitute a recommendation to buy or sell shares and does not take into account your goals or your financial situation. Our aim is 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 documents. Simply Wall St has no position in the mentioned stocks.

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