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 Aristocrat Leisure Limited (ASX:ALL).
Aristocrat Leisure has a ROE of 33%, based on the last twelve months. One way to conceptualize this, is that for each A$1 of shareholders' equity it has, the company made A$0.33 in profit.
How Do I Calculate Return On Equity?
The formula for return on equity is:
Return on Equity = Net Profit ÷ Shareholders' Equity
Or for Aristocrat Leisure:
33% = AU$632m ÷ AU$1.9b (Based on the trailing twelve months to March 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. The easiest way to calculate shareholders' equity is to subtract the company's total liabilities from the total assets.
What Does ROE Mean?
ROE looks at the amount a company earns relative to the money it has kept within the business. The 'return' is the profit over the last twelve months. That means that the higher the ROE, the more profitable the company is. So, as a general rule, a high ROE is a good thing. Clearly, then, one can use ROE to compare different companies.
Does Aristocrat Leisure Have A Good Return On Equity?
Arguably the easiest way to assess company's ROE is to compare it with the average in its industry. 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, Aristocrat Leisure has a higher ROE than the average (12%) in the Hospitality industry.
That is a good sign. I usually take a closer look when a company has a better ROE than industry peers. For example you might check if insiders are buying shares.
How Does Debt Impact Return On Equity?
Virtually all companies need money to invest in the business, to grow profits. That cash can come from issuing shares, retained earnings, or debt. 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. Thus the use of debt can improve ROE, albeit along with extra risk in the case of stormy weather, metaphorically speaking.
Aristocrat Leisure's Debt And Its 33% ROE
It's worth noting the significant use of debt by Aristocrat Leisure, leading to its debt to equity ratio of 1.56. While the ROE is impressive, that metric has clearly benefited from the company's use of debt. Debt increases risk and reduces options for the company in the future, so you generally want to see some good returns from using it.
The Key Takeaway
Return on equity is one way we can compare the business quality of different companies. A company that can achieve a high return on equity without debt could be considered a high quality business. All else being equal, a higher ROE is better.
But ROE is just one piece of a bigger puzzle, since high quality businesses often trade on high multiples of earnings. 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 take a peek at this data-rich interactive graph of forecasts for the company.
But note: Aristocrat Leisure 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.
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If you spot an error that warrants correction, please contact the editor at firstname.lastname@example.org. 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. Thank you for reading.