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A Closer Look At The Scotts Miracle-Gro Company's (NYSE:SMG) Impressive ROE

Simply Wall St

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. To keep the lesson grounded in practicality, we'll use ROE to better understand The Scotts Miracle-Gro Company (NYSE:SMG).

Scotts Miracle-Gro has a ROE of 71%, based on the last twelve months. That means that for every $1 worth of shareholders' equity, it generated $0.71 in profit.

See our latest analysis for Scotts Miracle-Gro

How Do You Calculate Return On Equity?

The formula for ROE is:

Return on Equity = Net Profit (from continuing operations) ÷ Shareholders' Equity

Or for Scotts Miracle-Gro:

71% = US$448m ÷ US$629m (Based on the trailing twelve months to December 2019.)

Most readers would understand what net profit is, but it’s worth explaining the concept of shareholders’ equity. It is the capital paid in by shareholders, plus any retained earnings. The easiest way to calculate shareholders' equity is to subtract the company's total liabilities from the total assets.

What Does Return On Equity Signify?

ROE looks at the amount a company earns relative to the money it has kept within the business. The 'return' is the amount earned after tax 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. That means it can be interesting to compare the ROE of different companies.

Does Scotts Miracle-Gro Have A Good ROE?

One simple way to determine if a company has a good return on equity is to compare it to the average for its industry. Importantly, this is far from a perfect measure, because companies differ significantly within the same industry classification. Pleasingly, Scotts Miracle-Gro has a superior ROE than the average (13%) company in the Chemicals industry.

NYSE:SMG Past Revenue and Net Income, February 11th 2020

That is a good sign. In my book, a high ROE almost always warrants a closer look. For example, I often check if insiders have been buying shares.

The Importance Of Debt To Return On Equity

Companies usually need to invest money to grow their profits. That cash can come from retained earnings, issuing new shares (equity), 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 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 Scotts Miracle-Gro's Debt And Its 71% Return On Equity

We think Scotts Miracle-Gro uses a lot of debt to boost returns, as it has a relatively high debt to equity ratio of 3.24. Its ROE is no doubt quite impressive, but it would probably be a lot lower without the use of significant leverage.

In Summary

Return on equity is one way we can compare the business quality of different companies. Companies that can achieve high returns on equity without too much debt are generally of good quality. 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 when a business is high quality, the market often bids it up to a price that reflects this. 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 Scotts Miracle-Gro 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.

If you spot an error that warrants correction, please contact the editor at editorial-team@simplywallst.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.

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. Thank you for reading.