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. To keep the lesson grounded in practicality, we’ll use ROE to better understand Allegiant Travel Company (NASDAQ:ALGT).
Allegiant Travel has a ROE of 23%, based on the last twelve months. One way to conceptualize this, is that for each $1 of shareholders’ equity it has, the company made $0.23 in profit.
How Do You Calculate ROE?
The formula for ROE is:
Return on Equity = Net Profit ÷ Shareholders’ Equity
Or for Allegiant Travel:
23% = US$182m ÷ US$805m (Based on the trailing twelve months to June 2019.)
Most know that net profit is the total earnings after all expenses, but the concept of shareholders’ equity is a little more complicated. It is the capital paid in by shareholders, plus any retained earnings. 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. That means that the higher the ROE, the more profitable the company is. So, all else equal, investors should like a high ROE. That means ROE can be used to compare two businesses.
Does Allegiant Travel Have A Good ROE?
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. You can see in the graphic below that Allegiant Travel has an ROE that is fairly close to the average for the Airlines industry (19%).
That isn’t amazing, but it is respectable. ROE doesn’t tell us if the share price is low, but it can inform us to the nature of the business. For those looking for a bargain, other factors may be more important. If you are like me, then you will not want to miss this free list of growing companies that insiders are buying.
How Does Debt Impact 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 two cases, the ROE will capture this use of capital to grow. In the latter case, the use of debt will improve the returns, but will not change the equity. That will make the ROE look better than if no debt was used.
Allegiant Travel’s Debt And Its 23% ROE
Allegiant Travel does use a significant amount of debt to increase returns. It has a debt to equity ratio of 1.72. While the ROE is impressive, that metric has clearly benefited from the company’s use of debt. Debt does bring extra risk, so it’s only really worthwhile when a company generates some decent returns from it.
The Bottom Line On ROE
Return on equity is a useful indicator of the ability of a business to generate profits and return them to shareholders. 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 take a peek at this data-rich interactive graph of forecasts for the company.
But note: Allegiant Travel 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.
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If you spot an error that warrants correction, please contact the editor at firstname.lastname@example.org. 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.