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. By way of learning-by-doing, we’ll look at ROE to gain a better understanding of IDEX Corporation (NYSE:IEX).
Over the last twelve months IDEX has recorded a ROE of 20%. Another way to think of that is that for every $1 worth of equity in the company, it was able to earn $0.20.
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How Do I Calculate Return On Equity?
The formula for return on equity is:
Return on Equity = Net Profit ÷ Shareholders’ Equity
Or for IDEX:
20% = 406.182 ÷ US$2.1b (Based on the trailing twelve months to September 2018.)
Most readers would understand what net profit is, but it’s worth explaining the concept of shareholders’ equity. It is all earnings retained by the company, plus any capital paid in by shareholders. You can calculate shareholders’ equity by subtracting the company’s total liabilities from its total assets.
What Does Return On Equity Mean?
ROE measures a company’s profitability against the profit it retains, and any outside investments. The ‘return’ is the amount earned after tax over the last twelve months. The higher the ROE, the more profit the company is making. So, all else equal, investors should like a high ROE. Clearly, then, one can use ROE to compare different companies.
Does IDEX 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. As is clear from the image below, IDEX has a better ROE than the average (13%) in the Machinery industry.
That’s what I like to see. I usually take a closer look when a company has a better ROE than industry peers. One data point to check is if insiders have bought shares recently.
How Does Debt Impact Return On Equity?
Most companies need money — from somewhere — to grow their profits. That cash can come from retained earnings, issuing new shares (equity), 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 use of debt will improve the returns, but will not change the equity. In this manner the use of debt will boost ROE, even though the core economics of the business stay the same.
Combining IDEX’s Debt And Its 20% Return On Equity
While IDEX does have some debt, with debt to equity of just 0.41, we wouldn’t say debt is excessive. Its very respectable ROE, combined with only modest debt, suggests the business is in good shape. Careful use of debt to boost returns is often very good for shareholders. However, it could reduce the company’s ability to take advantage of future opportunities.
The Key Takeaway
Return on equity is one way we can compare the business quality of different companies. In my book the highest quality companies have high return on equity, despite low debt. 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. It is important to consider other factors, such as future profit growth — and how much investment is required going forward. So you might want to take a peek at this data-rich interactive graph of forecasts for the company.
But note: IDEX 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.
To help readers see past the short term volatility of the financial market, we aim to bring you a long-term focused research analysis purely driven by fundamental data. Note that our analysis does not factor in the latest price-sensitive company announcements.
The author is an independent contributor and at the time of publication had no position in the stocks mentioned. For errors that warrant correction please contact the editor at editorial-team@simplywallst.com.