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 US Ecology, Inc. (NASDAQ:ECOL), by way of a worked example.
Over the last twelve months US Ecology has recorded a ROE of 13%. One way to conceptualize this, is that for each $1 of shareholders’ equity it has, the company made $0.13 in profit.
How Do I Calculate Return On Equity?
The formula for return on equity is:
Return on Equity = Net Profit ÷ Shareholders’ Equity
Or for US Ecology:
13% = US$51m ÷ US$377m (Based on the trailing twelve months to June 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. That means that the higher the ROE, the more profitable the company is. 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 US Ecology Have A Good Return On Equity?
Arguably the easiest way to assess company’s ROE is to compare it with the average in its industry. Importantly, this is far from a perfect measure, because companies differ significantly within the same industry classification. The image below shows that US Ecology has an ROE that is roughly in line with the Commercial Services industry average (14%).
That isn’t amazing, but it is respectable. ROE can give us a view about company quality, but many investors also look to other factors, such as whether there are insiders buying shares. For those who like to find winning investments this free list of growing companies with recent insider purchasing, could be just the ticket.
How Does Debt Impact ROE?
Virtually all companies need money to invest in the business, to grow profits. That cash can come from retained earnings, issuing new shares (equity), or debt. 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.
US Ecology’s Debt And Its 13% ROE
Although US Ecology does use debt, its debt to equity ratio of 0.89 is still low. The fact that it achieved a fairly good ROE with only modest debt suggests the business might be worth putting on your watchlist. Conservative use of debt to boost returns is usually a good move for shareholders, though it does leave the company more exposed to interest rate rises.
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.
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 you might want to check this FREE visualization of analyst forecasts for the company.
If you would prefer check out another company — one with potentially superior financials — then do not miss this free list of interesting companies, that have HIGH return on equity 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.