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 Willis Lease Finance Corporation (NASDAQ:WLFC), by way of a worked example.
Our data shows Willis Lease Finance has a return on equity of 16% for the last year. One way to conceptualize this, is that for each $1 of shareholders’ equity it has, the company made $0.16 in profit.
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How Do You Calculate Return On Equity?
The formula for ROE is:
Return on Equity = Net Profit ÷ Shareholders’ Equity
Or for Willis Lease Finance:
16% = US$54m ÷ US$357m (Based on the trailing twelve months to March 2019.)
Most readers would understand what net profit is, but it’s worth explaining the concept of shareholders’ equity. It is all the money paid into the company from shareholders, plus any earnings retained. You can calculate shareholders’ equity by subtracting the company’s total liabilities from its total assets.
What Does Return On Equity Signify?
ROE looks at the amount a company earns relative to the money it has kept within the business. The ‘return’ is the yearly profit. A higher profit will lead to a higher ROE. So, all else being equal, a high ROE is better than a low one. That means ROE can be used to compare two businesses.
Does Willis Lease Finance 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. Importantly, this is far from a perfect measure, because companies differ significantly within the same industry classification. As is clear from the image below, Willis Lease Finance has a better ROE than the average (11%) in the Trade Distributors 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, I often check if insiders have been 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 first and second cases, the ROE will reflect this use of cash for investment in the business. In the latter case, the debt required for growth will boost returns, but will not impact the shareholders’ equity. Thus the use of debt can improve ROE, albeit along with extra risk in the case of stormy weather, metaphorically speaking.
Willis Lease Finance’s Debt And Its 16% ROE
It seems that Willis Lease Finance uses a lot of debt to fund the business, since it has a high debt to equity ratio of 3.65. Its ROE is pretty good, but given the impact of the debt, we’re less than enthused, overall.
Return on equity is one way we can compare the business quality of different companies. Companies that can achieve high returns on equity without too much debt are generally of good quality. If two companies have the same ROE, then I would generally prefer the one with less debt.
But when a business is high quality, the market often bids it up to a price that reflects this. It is important to consider other factors, such as future profit growth — and how much investment is required going forward. You can see how the company has grow in the past by looking at this FREE detailed graph of past earnings, revenue and cash flow.
But note: Willis Lease Finance may not be the best stock to buy. So take a peek at this free list of interesting companies with 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.