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). By way of learning-by-doing, we'll look at ROE to gain a better understanding of CSW Industrials, Inc. (NASDAQ:CSWI).
Over the last twelve months CSW Industrials has recorded a ROE of 15%. That means that for every $1 worth of shareholders' equity, it generated $0.15 in profit.
How Do You Calculate ROE?
The formula for ROE is:
Return on Equity = Net Profit (from continuing operations) ÷ Shareholders' Equity
Or for CSW Industrials:
15% = US$44m ÷ US$286m (Based on the trailing twelve months to September 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. 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 yearly profit. That means that the higher the ROE, the more profitable the company is. So, all else equal, investors should like a high ROE. That means it can be interesting to compare the ROE of different companies.
Does CSW Industrials 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. As is clear from the image below, CSW Industrials has a better ROE than the average (12%) in the Building industry.
That's clearly a positive. 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.
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 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. Thus the use of debt can improve ROE, albeit along with extra risk in the case of stormy weather, metaphorically speaking.
Combining CSW Industrials's Debt And Its 15% Return On Equity
While CSW Industrials does have a tiny amount of debt, with debt to equity of just 0.043, we think the use of debt is very modest. Its very respectable ROE, combined with only modest debt, suggests the business is in good shape. Conservative use of debt to boost returns is usually a good move for shareholders, though it does leave the company more exposed to interest rate rises.
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 CSW Industrials 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 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.
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