Want to participate in a short research study? Help shape the future of investing tools and you could win a $250 gift card!
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). To keep the lesson grounded in practicality, we'll use ROE to better understand Ferro Corporation (NYSE:FOE).
Ferro has a ROE of 21%, based on the last twelve months. That means that for every $1 worth of shareholders' equity, it generated $0.21 in profit.
How Do I Calculate Return On Equity?
The formula for return on equity is:
Return on Equity = Net Profit ÷ Shareholders' Equity
Or for Ferro:
21% = US$80m ÷ US$386m (Based on the trailing twelve months to December 2018.)
Most know that net profit is the total earnings after all expenses, but the concept of shareholders' equity is a little more complicated. 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 ROE Signify?
ROE looks at the amount a company earns relative to the money it has kept within the business. The 'return' is the amount earned after tax over the last twelve months. A higher profit will lead to a higher ROE. So, as a general rule, a high ROE is a good thing. That means ROE can be used to compare two businesses.
Does Ferro 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, Ferro has a superior ROE than the average (15%) company in the Chemicals industry.
That's what I like to see. 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.
How Does Debt Impact Return On Equity?
Most companies need money -- from somewhere -- to grow their profits. That cash can come from retained earnings, issuing new shares (equity), or debt. 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. That will make the ROE look better than if no debt was used.
Combining Ferro's Debt And Its 21% Return On Equity
Ferro clearly uses a significant amount of debt to boost returns, as it has a debt to equity ratio of 2.14. while its ROE is respectable, it is worth keeping in mind that there is usually a limit to how much debt a company can use. Investors should think carefully about how a company might perform if it was unable to borrow so easily, because credit markets do change over time.
The Bottom Line On ROE
Return on equity is useful for comparing the quality of different businesses. 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. 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 Ferro 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.