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. By way of learning-by-doing, we’ll look at ROE to gain a better understanding of JB Foods Limited (SGX:BEW).
JB Foods has a ROE of 18%, based on the last twelve months. That means that for every SGD1 worth of shareholders’ equity, it generated SGD0.18 in profit.
Check out our latest analysis for JB Foods
How Do You Calculate ROE?
The formula for ROE is:
Return on Equity = Net Profit (from continuing operations) ÷ Shareholders’ Equity
Or for JB Foods:
18% = US$26m ÷ US$141m (Based on the trailing twelve months to December 2019.)
It’s easy to understand the ‘net profit’ part of that equation, but ‘shareholders’ equity’ requires further explanation. It is all the money paid into the company from shareholders, plus any earnings retained. 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, all else being equal, a high ROE is better than a low one. Clearly, then, one can use ROE to compare different companies.
Does JB Foods Have A Good Return On Equity?
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. Pleasingly, JB Foods has a superior ROE than the average (8.4%) company in the Food industry.
That’s clearly a positive. I usually take a closer look when a company has a better ROE than industry peers. For example, I often check if insiders have been buying shares.
How Does Debt Impact ROE?
Companies usually need to invest money to grow their profits. That cash can come from issuing shares, retained earnings, or debt. 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. In this manner the use of debt will boost ROE, even though the core economics of the business stay the same.
Combining JB Foods’s Debt And Its 18% Return On Equity
JB Foods does use a significant amount of debt to increase returns. It has a debt to equity ratio of 1.23. Its ROE is quite good but, it would have probably been lower without the use of debt. Debt does bring 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. In my book the highest quality companies have high return on equity, despite low debt. If two companies have the same ROE, then I would generally prefer the one with less debt.
But when a business is high quality, the market often bids it up to a price that reflects this. Profit growth rates, versus the expectations reflected in the price of the stock, are a particularly important to consider. So I think it may be worth checking this free this detailed graph of past earnings, revenue and cash flow.
If you would prefer check out another company — one with potentially superior financials — then do not miss thisfree 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 [email protected]. 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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