Read This Before Judging Citi Trends, Inc.'s (NASDAQ:CTRN) ROE

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Many investors are still learning about the various metrics that can be useful when analysing a stock. This article is for those who would like to learn about Return On Equity (ROE). We'll use ROE to examine Citi Trends, Inc. (NASDAQ:CTRN), by way of a worked example.

Over the last twelve months Citi Trends has recorded a ROE of 9.8%. That means that for every $1 worth of shareholders' equity, it generated $0.098 in profit.

See our latest analysis for Citi Trends

How Do You Calculate ROE?

The formula for return on equity is:

Return on Equity = Net Profit ÷ Shareholders' Equity

Or for Citi Trends:

9.8% = 19.274 ÷ US$196m (Based on the trailing twelve months to November 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 looks at the amount a company earns relative to the money it has kept within the business. The 'return' is the yearly profit. A higher profit will lead to a higher ROE. So, as a general rule, a high ROE is a good thing. That means ROE can be used to compare two businesses.

Does Citi Trends Have A Good ROE?

One simple way to determine if a company has a good return on equity is to compare it to the average for its industry. Importantly, this is far from a perfect measure, because companies differ significantly within the same industry classification. As is clear from the image below, Citi Trends has a lower ROE than the average (13%) in the Specialty Retail industry.

Unfortunately, that's sub-optimal. We prefer it when the ROE of a company is above the industry average, but it's not the be-all and end-all if it is lower. Nonetheless, it might be wise to check if insiders have been selling.

The Importance Of Debt To Return On Equity

Virtually all companies need money to invest in the business, to grow profits. The cash for investment can come from prior year profits (retained earnings), issuing new shares, or borrowing. 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. In this manner the use of debt will boost ROE, even though the core economics of the business stay the same.

Citi Trends's Debt And Its 9.8% ROE

Shareholders will be pleased to learn that Citi Trends has not one iota of net debt! So although its ROE isn't that impressive, we shouldn't judge it harshly on that metric, because it didn't use debt. At the end of the day, when a company has zero debt, it is in a better position to take future growth 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.

But ROE is just one piece of a bigger puzzle, since high quality businesses often trade on high multiples of earnings. Profit growth rates, versus the expectations reflected in the price of the stock, are a particularly important to consider. So I think it may be worth checking this freethis detailed graph of past earnings, revenue and cash flow .

But note: Citi Trends 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 editorial-team@simplywallst.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.