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Should We Be Delighted With DCC plc's (LON:DCC) ROE Of 11%?

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. We'll use ROE to examine DCC plc (LON:DCC), by way of a worked example.

Over the last twelve months DCC has recorded a ROE of 11%. Another way to think of that is that for every Â£1 worth of equity in the company, it was able to earn Â£0.11.

How Do You Calculate ROE?

The formula for return on equity is:

Return on Equity = Net Profit Ã· Shareholders' Equity

Or for DCC:

11% = UKÂ£263m Ã· UKÂ£2.4b (Based on the trailing twelve months to March 2019.)

Most readers would understand what net profit is, but itâ€™s worth explaining the concept of shareholdersâ€™ equity. It is all the money paid into the company from shareholders, plus any earnings retained. You can calculate shareholders' equity by subtracting the company's total liabilities from its total assets.

What Does Return On Equity Mean?

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. A higher profit will lead to a higher ROE. So, as a general rule, a high ROE is a good thing. Clearly, then, one can use ROE to compare different companies.

Does DCC 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. Pleasingly, DCC has a superior ROE than the average (6.6%) company in the Industrials industry.

That is a good sign. I usually take a closer look when a company has a better ROE than industry peers. For example you might check if insiders are buying shares.

The Importance Of Debt To Return On Equity

Most companies need money -- from somewhere -- to grow their profits. The cash for investment can come from prior year profits (retained earnings), issuing new shares, or borrowing. In the first and second cases, the ROE will reflect this use of cash for investment in the business. 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 DCC's Debt And Its 11% Return On Equity

DCC has a debt to equity ratio of 0.73, which is far from excessive. Its very respectable ROE, combined with only modest debt, suggests the business is in good shape. Judicious use of debt to improve returns can certainly be a good thing, although it does elevate risk slightly and reduce future optionality.

The Key Takeaway

Return on equity is useful for comparing the quality of different businesses. In my book the highest quality companies have high return on equity, despite low debt. 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. The rate at which profits are likely to grow, relative to the expectations of profit growth reflected in the current price, must be considered, too. So you might want to take a peek at this data-rich interactive graph of forecasts for the company.

If you would prefer check out another company -- one with potentially superior financials -- then do not miss this free list of interesting companies, that have HIGH return on equity 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 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. Thank you for reading.