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 GMS Inc. (NYSE:GMS), by way of a worked example.
Return on equity or ROE is an important factor to be considered by a shareholder because it tells them how effectively their capital is being reinvested. In simpler terms, it measures the profitability of a company in relation to shareholder's equity.
How Is ROE Calculated?
The formula for return on equity is:
Return on Equity = Net Profit (from continuing operations) ÷ Shareholders' Equity
So, based on the above formula, the ROE for GMS is:
3.8% = US$26m ÷ US$682m (Based on the trailing twelve months to July 2020).
The 'return' refers to a company's earnings over the last year. So, this means that for every $1 of its shareholder's investments, the company generates a profit of $0.04.
Does GMS 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. As shown in the graphic below, GMS has a lower ROE than the average (9.7%) in the Trade Distributors industry classification.
That's not what we like to see. Although, we think that a lower ROE could still mean that a company has the opportunity to better its returns with the use of leverage, provided its existing debt levels are low. A high debt company having a low ROE is a different story altogether and a risky investment in our books. To know the 4 risks we have identified for GMS visit our risks dashboard for free.
Why You Should Consider Debt When Looking At ROE
Companies usually need to invest money to grow their profits. That cash can come from issuing shares, retained earnings, or debt. 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 GMS' Debt And Its 3.8% Return On Equity
It's worth noting the high use of debt by GMS, leading to its debt to equity ratio of 1.40. With a fairly low ROE, and significant use of debt, it's hard to get excited about this business at the moment. Debt does bring extra risk, so it's only really worthwhile when a company generates some decent returns from it.
Return on equity is one way we can compare its business quality of different companies. In our books, 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 ROE is just one piece of a bigger puzzle, since high quality businesses often trade on high multiples of earnings. 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.
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.
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. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any stocks mentioned.
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