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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). We'll use ROE to examine Escalade, Incorporated (NASDAQ:ESCA), by way of a worked example.
Our data shows Escalade has a return on equity of 16% for the last year. One way to conceptualize this, is that for each $1 of shareholders' equity it has, the company made $0.16 in profit.
How Do I Calculate ROE?
The formula for return on equity is:
Return on Equity = Net Profit ÷ Shareholders' Equity
Or for Escalade:
16% = US$20m ÷ US$128m (Based on the trailing twelve months to December 2018.)
Most readers would understand what net profit is, but it’s worth explaining the concept of shareholders’ equity. 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 Return On Equity 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 amount earned after tax over the last twelve months. The higher the ROE, the more profit the company is making. So, as a general rule, a high ROE is a good thing. That means ROE can be used to compare two businesses.
Does Escalade Have A Good Return On Equity?
One simple way to determine if a company has a good return on equity is to compare it to the average for its industry. The limitation of this approach is that some companies are quite different from others, even within the same industry classification. You can see in the graphic below that Escalade has an ROE that is fairly close to the average for the Leisure industry (16%).
That's not overly surprising. ROE tells us about the quality of the business, but it does not give us much of an idea if the share price is cheap. For those who like to find winning investments this free list of growing companies with recent insider purchasing, could be just the ticket.
How Does Debt Impact ROE?
Most companies need money -- from somewhere -- to grow their profits. That cash can come from issuing shares, retained earnings, 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. That will make the ROE look better than if no debt was used.
Escalade's Debt And Its 16% ROE
One positive for shareholders is that Escalade does not have any net debt! Its ROE suggests it is a decent business; and the fact it is not leveraging returns indicates it is well worth watching. At the end of the day, when a company has zero debt, it is in a better position to take future growth opportunities.
Return on equity is a useful indicator of the ability of a business to generate profits and return them to shareholders. 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.
But ROE is just one piece of a bigger puzzle, since high quality businesses often trade on high multiples of earnings. 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 Escalade 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 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. Thank you for reading.