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 PFSweb Inc (NASDAQ:PFSW), by way of a worked example.
PFSweb has a ROE of 3.6%, based on the last twelve months. That means that for every $1 worth of shareholders’ equity, it generated $0.036 in profit.
How Do I Calculate ROE?
The formula for return on equity is:
Return on Equity = Net Profit ÷ Shareholders’ Equity
Or for PFSweb:
3.6% = 1.524 ÷ US$42m (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 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 ROE Mean?
ROE measures a company’s profitability against the profit it retains, and any outside investments. The ‘return’ is the yearly profit. That means that the higher the ROE, the more profitable the company is. So, all else equal, investors should like a high ROE. Clearly, then, one can use ROE to compare different companies.
Does PFSweb 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 shown in the graphic below, PFSweb has a lower ROE than the average (15%) in the it industry classification.
That certainly isn’t ideal. It is better when the ROE is above industry average, but a low one doesn’t necessarily mean the business is overpriced. Still, shareholders might want to check if insiders have been selling.
How Does Debt Impact Return On Equity?
Most companies need money — from somewhere — to grow their profits. That cash can come from retained earnings, issuing new shares (equity), or debt. 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 used for growth will improve returns, but won’t affect the total equity. That will make the ROE look better than if no debt was used.
Combining PFSweb’s Debt And Its 3.6% Return On Equity
PFSweb does use a significant amount of debt to increase returns. It has a debt to equity ratio of 1.02. Its ROE is quite low, even with the use of significant debt; that’s not a good result, in my opinion. Debt does bring some extra risk, so it’s only really worthwhile when a company generates some decent returns from it.
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. All else being equal, a higher ROE is better.
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. So you might want to check this FREE visualization of analyst forecasts for the company.
Of course PFSweb 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.
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 email@example.com.