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 Cohort plc (LON:CHRT).
Our data shows Cohort has a return on equity of 9.2% for the last year. One way to conceptualize this, is that for each £1 of shareholders’ equity it has, the company made £0.09 in profit.
See our latest analysis for Cohort
How Do I Calculate ROE?
The formula for ROE is:
Return on Equity = Net Profit (from continuing operations) ÷ Shareholders’ Equity
Or for Cohort:
9.2% = UK£6.8m ÷ UK£74m (Based on the trailing twelve months to October 2019.)
It’s easy to understand the ‘net profit’ part of that equation, but ‘shareholders’ equity’ requires further explanation. 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 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. That means it can be interesting to compare the ROE of different companies.
Does Cohort 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. If you look at the image below, you can see Cohort has a similar ROE to the average in the Aerospace & Defense industry classification (9.2%).
AIM:CHRT Past Revenue and Net Income March 26th 2020
That’s not overly surprising. ROE can give us a view about company quality, but many investors also look to other factors, such as whether there are insiders buying shares. For those who like to find winning investments this free list of growing companies with recent insider purchasing, could be just the ticket.
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 case of the first and second options, the ROE will reflect this use of cash, for growth. In the latter case, the debt used for growth will improve returns, but won’t affect the total equity. That will make the ROE look better than if no debt was used.
Combining Cohort’s Debt And Its 9.2% Return On Equity
Cohort has a debt to equity ratio of 0.34, which is far from excessive. The fact that it achieved a fairly good ROE with only modest debt suggests the business might be worth putting on your watchlist. 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.
But It’s Just One Metric
Return on equity is one way we can compare the business quality of different companies. Companies that can achieve high returns on equity without too much debt are generally of good quality. 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 check this FREE visualization of analyst forecasts for the company.
Of course Cohort may not be the best stock to buy. So you may wish to see this free collection of other companies that have 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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