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 Northwest Natural Holding Company (NYSE:NWN), by way of a worked example.
Northwest Natural Holding has a ROE of 7.5%, 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 $0.08.
How Do You Calculate ROE?
The formula for ROE is:
Return on Equity = Net Profit ÷ Shareholders' Equity
Or for Northwest Natural Holding:
7.5% = US$64m ÷ US$845m (Based on the trailing twelve months to September 2019.)
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. 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 measures a company's profitability against the profit it retains, and any outside investments. The 'return' is the yearly profit. A higher profit will lead to a higher ROE. So, all else equal, investors should like a high ROE. That means it can be interesting to compare the ROE of different companies.
Does Northwest Natural Holding Have A Good ROE?
By comparing a company's ROE with its industry average, we can get a quick measure of how good it is. However, this method is only useful as a rough check, because companies do differ quite a bit within the same industry classification. If you look at the image below, you can see Northwest Natural Holding has a similar ROE to the average in the Gas Utilities industry classification (8.3%).
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. I will like Northwest Natural Holding better if I see some big insider buys. While we wait, check out this free list of growing companies with considerable, recent, insider buying.
How Does Debt Impact 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 case of the first and second options, the ROE will reflect this use of cash, for growth. In the latter case, the debt used for growth will improve returns, but won't affect the total equity. In this manner the use of debt will boost ROE, even though the core economics of the business stay the same.
Northwest Natural Holding's Debt And Its 7.5% ROE
Northwest Natural Holding does use a significant amount of debt to increase returns. It has a debt to equity ratio of 1.14. The company doesn't have a bad ROE, but it is less than ideal tht it has had to use debt to achieve its returns. Debt increases risk and reduces options for the company in the future, so you generally want to see some good returns from using it.
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. If two companies have the same ROE, then I would generally prefer the one with less debt.
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.
If you would prefer check out another company -- one with potentially superior financials -- then do not miss thisfree list of interesting companies, that have HIGH return on equity 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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