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Many investors are still learning about the various metrics that can be useful when analysing a stock. This article is for those who would like to learn about Return On Equity (ROE). We'll use ROE to examine Deere & Company (NYSE:DE), by way of a worked example.
Deere has a ROE of 30%, based on the last twelve months. One way to conceptualize this, is that for each $1 of shareholders' equity it has, the company made $0.30 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 Deere:
30% = US$3.4b ÷ US$11b (Based on the trailing twelve months to January 2019.)
Most know that net profit is the total earnings after all expenses, but the concept of shareholders' equity is a little more complicated. It is all earnings retained by the company, plus any capital paid in by shareholders. 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, as a general rule, a high ROE is a good thing. That means ROE can be used to compare two businesses.
Does Deere 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, Deere has a higher ROE than the average (14%) in the Machinery industry.
That's what I like to see. We think a high ROE, alone, is usually enough to justify further research into a company. One data point to check is if insiders have bought shares recently.
Why You Should Consider Debt When Looking At ROE
Companies usually need to invest money to grow their profits. The cash for investment can come from prior year profits (retained earnings), issuing new shares, or borrowing. 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. Thus the use of debt can improve ROE, albeit along with extra risk in the case of stormy weather, metaphorically speaking.
Deere's Debt And Its 30% ROE
It appears that Deere makes extensive use of debt to improve its returns, because it has a relatively high debt to equity ratio of 3.82. Its ROE is clearly quite good, but it would probably be significantly lower without all the debt.
Return on equity is a useful indicator of the ability of a business to generate profits and return them to shareholders. 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.
But ROE is just one piece of a bigger puzzle, since high quality businesses often trade on high multiples of earnings. Profit growth rates, versus the expectations reflected in the price of the stock, are a particularly important to consider. So you might want to check this FREE visualization of analyst forecasts for the company.
Of course Deere 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.
We aim to bring you long-term focused research analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material.
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.