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 Sotheby’s (NYSE:BID), by way of a worked example.
Over the last twelve months Sotheby’s has recorded a ROE of 17%. Another way to think of that is that for every $1 worth of equity in the company, it was able to earn $0.17.
How Do You Calculate Return On Equity?
The formula for return on equity is:
Return on Equity = Net Profit ÷ Shareholders’ Equity
Or for Sotheby’s:
17% = US$102m ÷ US$607m (Based on the trailing twelve months to June 2018.)
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. Shareholders’ equity can be calculated by subtracting the total liabilities of the company from the total assets of the company.
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 profit over the last twelve months. A higher profit will lead to a a higher ROE. So, all else equal, investors should like a high ROE. That means it can be interesting to compare the ROE of different companies.
Does Sotheby’s Have A Good ROE?
Arguably the easiest way to assess company’s ROE is to compare it with the average in its industry. The limitation of this approach is that some companies are quite different from others, even within the same industry classification. As you can see in the graphic below, Sotheby’s has a higher ROE than the average (13%) in the consumer services industry.
That is a good sign. 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 Return On Equity?
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 debt required for growth will boost returns, but will not impact the shareholders’ equity. In this manner the use of debt will boost ROE, even though the core economics of the business stay the same.
Combining Sotheby’s’s Debt And Its 17% Return On Equity
Sotheby’s does use a significant amount of debt to increase returns. It has a debt to equity ratio of 1.20. Its ROE is quite good but, it would have probably been lower without the use of debt. Debt does bring some 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 around the same level of debt to equity, and one has a higher ROE, I’d generally prefer the one with higher ROE.
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 I think it may be worth checking this free report on analyst forecasts for the company.
Of course, you might find a fantastic investment by looking elsewhere. So take a peek at this free list of interesting companies.
To help readers see past the short term volatility of the financial market, we aim to bring you a long-term focused research analysis purely driven by fundamental data. Note that our analysis does not factor in the latest price-sensitive company announcements.
The author is an independent contributor and at the time of publication had no position in the stocks mentioned. For errors that warrant correction please contact the editor at email@example.com.