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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 Acorn International, Inc. (NYSE:ATV), by way of a worked example.
Over the last twelve months Acorn International has recorded a ROE of 42%. One way to conceptualize this, is that for each $1 of shareholders’ equity it has, the company made $0.42 in profit.
How Do I Calculate ROE?
The formula for ROE is:
Return on Equity = Net Profit ÷ Shareholders’ Equity
Or for Acorn International:
42% = US$30m ÷ US$73m (Based on the trailing twelve months to December 2018.)
It’s easy to understand the ‘net profit’ part of that equation, but ‘shareholders’ equity’ requires further explanation. It is the capital paid in by shareholders, plus any retained earnings. Shareholders’ equity can be calculated by subtracting the total liabilities of the company from the total assets of the company.
What Does Return On Equity Mean?
ROE measures a company’s profitability against the profit it retains, and any outside investments. The ‘return’ is the amount earned after tax over the last twelve months. 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 Acorn International 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. However, this method is only useful as a rough check, because companies do differ quite a bit within the same industry classification. Pleasingly, Acorn International has a superior ROE than the average (12%) company in the Online Retail industry.
That is a good sign. We think a high ROE, alone, is usually enough to justify further research into a company. For example you might check if insiders are buying shares.
How Does Debt Impact ROE?
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 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. That will make the ROE look better than if no debt was used.
Combining Acorn International’s Debt And Its 42% Return On Equity
Shareholders will be pleased to learn that Acorn International has not one iota of net debt! Its high ROE indicates the business is high quality, but the fact that this was achieved without leverage is veritably impressive. After all, when a company has a strong balance sheet, it can often find ways to invest in growth, even if it takes some time.
The Key Takeaway
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. All else being equal, a higher ROE is better.
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. You can see how the company has grow in the past by looking at this FREE detailed graph of past earnings, revenue and cash flow.
Of course Acorn International may not be the best stock to buy. So you may wish to see this free collection of other companies that have 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 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.