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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. By way of learning-by-doing, we'll look at ROE to gain a better understanding of Matthews International Corporation (NASDAQ:MATW).
Over the last twelve months Matthews International has recorded a ROE of 8.5%. One way to conceptualize this, is that for each $1 of shareholders' equity it has, the company made $0.085 in profit.
How Do I Calculate ROE?
The formula for return on equity is:
Return on Equity = Net Profit ÷ Shareholders' Equity
Or for Matthews International:
8.5% = US$73m ÷ US$847m (Based on the trailing twelve months to March 2019.)
It's easy to understand the 'net profit' part of that equation, but 'shareholders' equity' requires further explanation. It is all earnings retained by the company, plus any capital paid in by shareholders. Shareholders' equity can be calculated by subtracting the total liabilities of the company from the total assets of the company.
What Does ROE Mean?
ROE looks at the amount a company earns relative to the money it has kept within the business. The 'return' is the profit over the last twelve months. A higher profit will lead to a higher ROE. So, all else being equal, a high ROE is better than a low one. That means ROE can be used to compare two businesses.
Does Matthews International 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 shown in the graphic below, Matthews International has a lower ROE than the average (13%) in the Commercial Services industry classification.
That's not what we like to see. We'd prefer see an ROE above the industry average, but it might not matter if the company is undervalued. Still, shareholders might want to check if insiders have been selling.
How Does Debt Impact Return On Equity?
Virtually all companies need money to invest in the business, to grow 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 use of debt will improve the returns, but will not change the equity. In this manner the use of debt will boost ROE, even though the core economics of the business stay the same.
Matthews International's Debt And Its 8.5% ROE
Matthews International clearly uses a significant amount of debt to boost returns, as it has a debt to equity ratio of 1.15. While the ROE isn't too bad, it would probably be a lot lower if the company was forced to reduce debt. Investors should think carefully about how a company might perform if it was unable to borrow so easily, because credit markets do change over time.
The Key Takeaway
Return on equity is a useful indicator of the ability of a business to generate profits and return them to shareholders. In my book the highest quality companies have high return on equity, despite low debt. 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. Profit growth rates, versus the expectations reflected in the price of the stock, are a particularly important to consider. So I think it may be worth checking this free report on analyst forecasts for the company.
Of course Matthews International 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 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.