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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 CarMax, Inc. (NYSE:KMX), by way of a worked example.
Over the last twelve months CarMax has recorded a ROE of 25%. Another way to think of that is that for every $1 worth of equity in the company, it was able to earn $0.25.
How Do I Calculate Return On Equity?
The formula for ROE is:
Return on Equity = Net Profit ÷ Shareholders' Equity
Or for CarMax:
25% = US$842m ÷ US$3.4b (Based on the trailing twelve months to February 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 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 Signify?
ROE measures a company's profitability against the profit it retains, and any outside investments. The 'return' is the yearly profit. A higher profit will lead to 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 CarMax 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 is clear from the image below, CarMax has a better ROE than the average (12%) in the Specialty Retail industry.
That's what I like to see. We think a high ROE, alone, is usually enough to justify further research into a company. For example, I often check if insiders have been buying shares .
Why You Should Consider Debt When Looking At ROE
Most companies need money -- from somewhere -- to grow their profits. That cash can come from retained earnings, issuing new shares (equity), or debt. In the first two cases, the ROE will capture this use of capital to grow. In the latter case, the debt used for growth will improve returns, but won't affect the total equity. Thus the use of debt can improve ROE, albeit along with extra risk in the case of stormy weather, metaphorically speaking.
CarMax's Debt And Its 25% ROE
It appears that CarMax makes extensive use of debt to improve its returns, because it has a relatively high debt to equity ratio of 4.23. So although the company has an impressive ROE, that figure would be a lot lower without the use of debt.
Return on equity is useful for comparing the quality of different businesses. 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.
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 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.
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 email@example.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. Thank you for reading.