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 Getty Realty Corp (NYSE:GTY), by way of a worked example.
Our data shows Getty Realty has a return on equity of 8.4% for the last year. Another way to think of that is that for every $1 worth of equity in the company, it was able to earn $0.084.
How Do I Calculate Return On Equity?
The formula for ROE is:
Return on Equity = Net Profit ÷ Shareholders’ Equity
Or for Getty Realty:
8.4% = US$48m ÷ US$572m (Based on the trailing twelve months to September 2018.)
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. You can calculate shareholders’ equity by subtracting the company’s total liabilities from its 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 amount earned after tax over the last twelve months. 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 Getty Realty Have A Good Return On Equity?
One simple way to determine if a company has a good return on equity is to compare it to the average for its industry. However, this method is only useful as a rough check, because companies do differ quite a bit within the same industry classification. As is clear from the image below, Getty Realty has a better ROE than the average (6.8%) in the reits industry.
That’s clearly a positive. In my book, a high ROE almost always warrants a closer look. One data point to check is if insiders have bought shares recently.
The Importance Of Debt To Return On Equity
Most companies need money — from somewhere — to grow their profits. That cash can come from issuing shares, retained earnings, or debt. 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. In this manner the use of debt will boost ROE, even though the core economics of the business stay the same.
Combining Getty Realty’s Debt And Its 8.4% Return On Equity
Although Getty Realty does use debt, its debt to equity ratio of 0.74 is still low. Its ROE isn’t particularly impressive, but the debt levels are quite modest, so the business probably has some real potential. Judicious use of debt to improve returns can certainly be a good thing, although it does elevate risk slightly and reduce future optionality.
The Bottom Line On ROE
Return on equity is one way we can compare the business quality of different companies. A company that can achieve a high return on equity without debt could be considered a high quality business. All else being equal, a higher ROE is better.
But ROE is just one piece of a bigger puzzle, since high quality businesses often trade on high multiples of earnings. 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: Getty Realty 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 firstname.lastname@example.org.