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 Escalade, Incorporated (NASDAQ:ESCA), by way of a worked example.
Over the last twelve months Escalade has recorded a ROE of 6.6%. Another way to think of that is that for every $1 worth of equity in the company, it was able to earn $0.07.
How Do You Calculate ROE?
The formula for ROE is:
Return on Equity = Net Profit (from continuing operations) ÷ Shareholders’ Equity
Or for Escalade:
6.6% = US$8.3m ÷ US$126m (Based on the trailing twelve months to October 2019.)
It’s easy to understand the ‘net profit’ part of that equation, but ‘shareholders’ equity’ requires further explanation. It is all earnings retained by the company, plus any capital paid in by shareholders. The easiest way to calculate shareholders’ equity is to subtract the company’s total liabilities from the total assets.
What Does Return On Equity Mean?
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, as a general rule, a high ROE is a good thing. That means ROE can be used to compare two businesses.
Does Escalade 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. The limitation of this approach is that some companies are quite different from others, even within the same industry classification. If you look at the image below, you can see Escalade has a lower ROE than the average (13%) in the Leisure industry classification.
Unfortunately, that’s sub-optimal. It is better when the ROE is above industry average, but a low one doesn’t necessarily mean the business is overpriced. Nonetheless, it might be wise to check if insiders have been selling.
How Does Debt Impact ROE?
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 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.
Combining Escalade’s Debt And Its 6.6% Return On Equity
Although Escalade does use a little debt, its debt to equity ratio of just 0.042 is very low. Its ROE isn’t particularly impressive, but the debt levels are quite modest, so the business probably has some real potential. 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.
But It’s Just One Metric
Return on equity is useful for comparing the quality of different businesses. 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. It is important to consider other factors, such as future profit growth — and how much investment is required going forward. Check the past profit growth by Escalade by looking at this visualization of past earnings, revenue and cash flow.
Of course, you might find a fantastic investment by looking elsewhere. So take a peek at this free list of interesting companies.
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.
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