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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. By way of learning-by-doing, we’ll look at ROE to gain a better understanding of Aristocrat Leisure Limited (ASX:ALL).
Aristocrat Leisure has a ROE of 31%, based on the last twelve months. One way to conceptualize this, is that for each A$1 of shareholders’ equity it has, the company made A$0.31 in profit.
How Do I Calculate ROE?
The formula for ROE is:
Return on Equity = Net Profit ÷ Shareholders’ Equity
Or for Aristocrat Leisure:
31% = AU$543m ÷ AU$1.7b (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 the capital paid in by shareholders, plus any retained earnings. 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?
ROE looks at the amount a company earns relative to the money it has kept within the business. The ‘return’ is the amount earned after tax over the last twelve months. A higher profit will lead to a higher ROE. So, all else equal, investors should like a high ROE. That means it can be interesting to compare the ROE of different companies.
Does Aristocrat Leisure 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. However, this method is only useful as a rough check, because companies do differ quite a bit within the same industry classification. Pleasingly, Aristocrat Leisure has a superior ROE than the average (11%) company in the Hospitality industry.
That’s what I like to see. We think a high ROE, alone, is usually enough to justify further research into a company. For example, I often check if insiders have been buying shares .
How Does Debt Impact 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 two cases, the ROE will capture this use of capital to grow. In the latter case, the debt used for growth will improve returns, but won’t affect the total equity. In this manner the use of debt will boost ROE, even though the core economics of the business stay the same.
Combining Aristocrat Leisure’s Debt And Its 31% Return On Equity
Aristocrat Leisure does use a significant amount of debt to increase returns. It has a debt to equity ratio of 1.66. While the ROE is impressive, that metric has clearly benefited from the company’s use of debt. Investors should think carefully about how a company might perform if it was unable to borrow so easily, because credit markets do change over time.
Return on equity is useful for comparing the quality of different businesses. 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.
But when a business is high quality, the market often bids it up to a price that reflects this. 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.
But note: Aristocrat Leisure 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 firstname.lastname@example.org. 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.