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One of the best investments we can make is in our own knowledge and skill set. With that in mind, this article will work through how we can use Return On Equity (ROE) to better understand a business. We’ll use ROE to examine World Wrestling Entertainment, Inc. (NYSE:WWE), by way of a worked example.
World Wrestling Entertainment has a ROE of 24%, based on the last twelve months. That means that for every $1 worth of shareholders’ equity, it generated $0.24 in profit.
How Do I Calculate Return On Equity?
The formula for ROE is:
Return on Equity = Net Profit ÷ Shareholders’ Equity
Or for World Wrestling Entertainment:
24% = US$76m ÷ US$313m (Based on the trailing twelve months to March 2019.)
Most know that net profit is the total earnings after all expenses, but the concept of shareholders’ equity is a little more complicated. It is all the money paid into the company from shareholders, plus any earnings retained. The easiest way to calculate shareholders’ equity is to subtract the company’s total liabilities from the total assets.
What Does Return On Equity Signify?
Return on Equity measures a company’s profitability against the profit it has kept for the business (plus any capital injections). The ‘return’ is the yearly profit. That means that the higher the ROE, the more profitable the company is. So, all else equal, investors should like a high ROE. That means it can be interesting to compare the ROE of different companies.
Does World Wrestling Entertainment Have A Good Return On Equity?
One simple way to determine if a company has a good return on equity is to compare it to the average for its industry. The limitation of this approach is that some companies are quite different from others, even within the same industry classification. Pleasingly, World Wrestling Entertainment has a superior ROE than the average (16%) company in the Entertainment industry.
That’s what I like to see. I usually take a closer look when a company has a better ROE than industry peers. For example you might check if insiders are buying shares.
The Importance Of Debt To Return On Equity
Companies usually need to invest money 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. In this manner the use of debt will boost ROE, even though the core economics of the business stay the same.
Combining World Wrestling Entertainment’s Debt And Its 24% Return On Equity
Although World Wrestling Entertainment does use debt, its debt to equity ratio of 0.73 is still low. The combination of modest debt and a very impressive ROE does suggest that the business is high quality. Judicious use of debt to improve returns can certainly be a good thing, although it does elevate risk slightly and reduce future optionality.
Return on equity is one way we can compare the 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 around the same level of debt to equity, and one has a higher ROE, I’d generally prefer the one with higher ROE.
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 free report on analyst forecasts for the company.
Of course World Wrestling Entertainment 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.
We aim to bring you long-term focused research analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material.
If you spot an error that warrants correction, please contact the editor at email@example.com. This article by Simply Wall St is general in nature. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. Simply Wall St has no position in the stocks mentioned. Thank you for reading.