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 Avon Rubber p.l.c. (LON:AVON), by way of a worked example.
Over the last twelve months Avon Rubber has recorded a ROE of 17%. One way to conceptualize this, is that for each £1 of shareholders’ equity it has, the company made £0.17 in profit.
See our latest analysis for Avon Rubber
How Do You Calculate Return On Equity?
The formula for return on equity is:
Return on Equity = Net Profit (from continuing operations) ÷ Shareholders’ Equity
Or for Avon Rubber:
17% = UK£14m ÷ UK£86m (Based on the trailing twelve months to September 2019.)
Most readers would understand what net profit is, but it’s worth explaining the concept of shareholders’ equity. It is all the money paid into the company from shareholders, plus any earnings retained. You can calculate shareholders’ equity by subtracting the company’s total liabilities from its total assets.
What Does ROE Signify?
Return on Equity measures a company’s profitability against the profit it has kept for the business (plus any capital injections). The ‘return’ is the yearly profit. That means that the higher the ROE, the more profitable the company is. 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 Avon Rubber 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. Importantly, this is far from a perfect measure, because companies differ significantly within the same industry classification. As is clear from the image below, Avon Rubber has a better ROE than the average (9.2%) in the Aerospace & Defense industry.
LSE:AVON Past Revenue and Net Income April 1st 2020
That’s what I like to see. I usually take a closer look when a company has a better ROE than industry peers. One data point to check is if insiders have bought shares recently.
How Does Debt Impact 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 first and second cases, the ROE will reflect this use of cash for investment in the business. In the latter case, the debt required for growth will boost returns, but will not impact the shareholders’ equity. That will make the ROE look better than if no debt was used.
Avon Rubber’s Debt And Its 17% ROE
Avon Rubber has a debt to equity ratio of just 0.0011, which is very low. Its very respectable ROE, combined with only modest debt, suggests the business is in good shape. Careful use of debt to boost returns is often very good for shareholders. However, it could reduce the company’s ability to take advantage of future opportunities.
The Key Takeaway
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. 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. The rate at which profits are likely to grow, relative to the expectations of profit growth reflected in the current price, must be considered, too. So you might want to take a peek at this data-rich interactive graph of forecasts for the company.
But note: Avon Rubber 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.
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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