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 Eckoh plc (LON:ECK), by way of a worked example.
Over the last twelve months Eckoh has recorded a ROE of 12%. That means that for every £1 worth of shareholders’ equity, it generated £0.12 in profit.
How Do You Calculate Return On Equity?
The formula for ROE is:
Return on Equity = Net Profit ÷ Shareholders’ Equity
Or for Eckoh:
12% = UK£3m ÷ UK£22m (Based on the trailing twelve months to March 2018.)
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. The easiest way to calculate shareholders’ equity is to subtract the company’s total liabilities from the total assets.
What Does ROE Signify?
ROE measures a company’s profitability against the profit it retains, and any outside investments. The ‘return’ is the profit over the last twelve months. 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 Eckoh 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. The limitation of this approach is that some companies are quite different from others, even within the same industry classification. The image below shows that Eckoh has an ROE that is roughly in line with the it industry average (12%).
That’s neither particularly good, nor bad. ROE can change from year to year, based on decisions that have been made in the past. So savvy investors often note how long the CEO has been in that position.
Why You Should Consider Debt When Looking At ROE
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.
Eckoh’s Debt And Its 12% ROE
While Eckoh does have some debt, with debt to equity of just 0.21, we wouldn’t say debt is excessive. The fact that it achieved a fairly good ROE with only modest debt suggests the business might be worth putting on your watchlist. 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 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.
Having said that, while ROE is a useful indicator of business quality, you’ll have to look at a whole range of factors to determine the right price to buy a stock. 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 I think it may be worth checking this free report on analyst forecasts for the company.
Of course, you might find a fantastic investment by looking elsewhere. So take a peek at this free list of interesting companies.
To help readers see past the short term volatility of the financial market, we aim to bring you a long-term focused research analysis purely driven by fundamental data. Note that our analysis does not factor in the latest price-sensitive company announcements.
The author is an independent contributor and at the time of publication had no position in the stocks mentioned. For errors that warrant correction please contact the editor at firstname.lastname@example.org.