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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. We'll use ROE to examine The Gorman-Rupp Company (NYSE:GRC), by way of a worked example.
Gorman-Rupp has a ROE of 13%, based on the last twelve months. Another way to think of that is that for every $1 worth of equity in the company, it was able to earn $0.13.
How Do You Calculate ROE?
The formula for return on equity is:
Return on Equity = Net Profit ÷ Shareholders' Equity
Or for Gorman-Rupp:
13% = US$38m ÷ US$297m (Based on the trailing twelve months to March 2019.)
Most readers would understand what net profit is, but it’s worth explaining the concept of shareholders’ equity. 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 Return On Equity Mean?
ROE measures a company's profitability against the profit it retains, and any outside investments. The 'return' is the yearly profit. The higher the ROE, the more profit the company is making. So, all else equal, investors should like a high ROE. Clearly, then, one can use ROE to compare different companies.
Does Gorman-Rupp 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. 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 Gorman-Rupp has an ROE that is fairly close to the average for the Machinery industry (14%).
That's neither particularly good, nor bad. 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. I will like Gorman-Rupp better if I see some big insider buys. While we wait, check out this free list of growing companies with considerable, recent, insider buying.
The Importance Of Debt To Return On Equity
Companies usually need to invest money to grow their profits. That cash can come from issuing shares, retained earnings, or debt. In the case of the first and second options, the ROE will reflect this use of cash, for growth. 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 Gorman-Rupp's Debt And Its 13% Return On Equity
Although Gorman-Rupp does use a little debt, its debt to equity ratio of just 0.00093 is very low. The fact that it achieved a fairly good ROE with only modest debt suggests the business might be worth putting on your watchlist. 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 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.
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 you might want to check this FREE visualization of analyst forecasts for the company.
Of course Gorman-Rupp 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.