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). By way of learning-by-doing, we’ll look at ROE to gain a better understanding of Etsy, Inc. (NASDAQ:ETSY).
ROE or return on equity is a useful tool to assess how effectively a company can generate returns on the investment it received from its shareholders. In simpler terms, it measures the profitability of a company in relation to shareholder’s equity.
See our latest analysis for Etsy
How To Calculate Return On Equity?
Return on equity can be calculated by using the formula:
Return on Equity = Net Profit (from continuing operations) ÷ Shareholders’ Equity
So, based on the above formula, the ROE for Etsy is:
24% = US$96m ÷ US$407m (Based on the trailing twelve months to December 2019).
The ‘return’ is the yearly profit. One way to conceptualize this is that for each $1 of shareholders’ capital it has, the company made $0.24 in profit.
Does Etsy Have A Good ROE?
By comparing a company’s ROE with its industry average, we can get a quick measure of how good it is. However, this method is only useful as a rough check, because companies do differ quite a bit within the same industry classification. As you can see in the graphic below, Etsy has a higher ROE than the average (11%) in the Online Retail industry.
That’s clearly a positive. Bear in mind, a high ROE doesn’t always mean superior financial performance. A higher proportion of debt in a company’s capital structure may also result in a high ROE, where the high debt levels could be a huge risk . Our risks dashboardshould have the 2 risks we have identified for Etsy.
Why You Should Consider Debt When Looking At 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 case of the first and second options, the ROE will reflect this use of cash, for growth. 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.
Etsy’s Debt And Its 24% ROE
Etsy clearly uses a high amount of debt to boost returns, as it has a debt to equity ratio of 1.93. Its ROE is pretty impressive but, it would have probably been lower without the use of debt. Investors should think carefully about how a company might perform if it was unable to borrow so easily, because credit markets do change over time.
Conclusion
Return on equity is a useful indicator of the ability of a business to generate profits and return them to shareholders. Companies that can achieve high returns on equity without too much debt are generally of good quality. If two companies have around the same level of debt to equity, and one has a higher ROE, I’d generally prefer the one with higher ROE.
But when a business is high quality, the market often bids it up to a price that reflects this. 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.
If you would prefer check out another company — one with potentially superior financials — then do not miss this free list of interesting companies, that have HIGH return on equity and low debt.
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.
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