While some investors are already familiar with financial metrics (hat tip), this article is for those who want to learn about return on equity (ROE) and its importance. As a practical example, using ROE he looks at GlobalData Plc (LON:DATA).
ROE or return on equity is a useful tool for evaluating how effectively a company can generate returns on the investment it receives from its shareholders. In other words, it is a profitability ratio that measures the rate of return on the capital provided by a company’s shareholders.
Check out our latest analysis for GlobalData.
How do I calculate return on equity?
of Formula for calculating return on equity teeth:
Return on equity = Net income (from continuing operations) ÷ Shareholders’ equity
So, based on the above formula, GlobalData’s ROE is:
64% = GBP 38 million ÷ GBP 59 million (based on the trailing twelve months to June 2023).
“Earnings” is the amount of your after-tax earnings over the past 12 months. One way he conceptualizes this is that for every £1 of shareholders’ equity, the company made his £0.64 in profit.
Does GlobalData have a good return on equity?
By comparing a company’s ROE with the industry average, you can easily measure how well a company performs. A limitation of this approach is that some companies are very different from others, even within the same industry classification. As evident from the image below, GlobalData has a better ROE than the average (14%) in the Professional Services industry.
That’s what we want. Note that a high ROE does not necessarily mean good financial performance. Apart from changes in net income, a high ROE can also be a result of high debt relative to equity, which indicates risk.
The importance of debt to increase 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 his second cases, ROE reflects the use of cash for investment in the business. In the latter case, using debt for growth improves returns but does not affect total capital. So, figuratively speaking, the use of debt allows him to improve ROE, although it involves extra risk in case of stormy weather.
GlobalData’s debt and ROE of 64%
GlobalData has a very high debt-to-equity ratio of 4.37, which suggests that it uses a large amount of debt to fund its operations. Therefore, while the company has an excellent ROE, it may not have been able to achieve this without making significant use of debt.
conclusion
Return on equity is one way that you can compare the quality of business of different companies. According to our book, the highest quality companies have a higher return on equity despite having less debt. If two companies have the same ROE, I usually prefer the one with less debt.
That said, while ROE is a useful indicator of the quality of a business, you need to consider a variety of factors to determine the right price to buy a stock. Earnings growth rates and the expectations reflected in the share price are particularly important to consider.So I think it’s worth checking this free A report on analyst forecasts for a company.
of course, You may find a great investment if you look elsewhere. So take a look at this free List of interesting companies.
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This article by Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts using only unbiased methodologies, and articles are not intended to be financial advice. This is not a recommendation to buy or sell any stock, and does not take into account your objectives or financial situation. We aim to provide long-term, focused analysis based on fundamental data. Note that our analysis may not factor in the latest announcements or qualitative material from price-sensitive companies. Simply Wall St has no position in any stocks mentioned.
