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 Games Workshop Group PLC (LON:GAW), by way of a worked example.
Our data shows Games Workshop Group has a return on equity of 67% for the last year. That means that for every £1 worth of shareholders' equity, it generated £0.67 in profit.
How Do I Calculate ROE?
The formula for return on equity is:
Return on Equity = Net Profit (from continuing operations) ÷ Shareholders' Equity
Or for Games Workshop Group:
67% = UK£80m ÷ UK£121m (Based on the trailing twelve months to December 2019.)
It's easy to understand the 'net profit' part of that equation, but 'shareholders' equity' requires further explanation. It is the capital paid in by shareholders, plus any retained earnings. The easiest way to calculate shareholders' equity is to subtract the company's total liabilities from the total assets.
What Does Return On Equity Mean?
ROE looks at the amount a company earns relative to the money it has kept within the business. The 'return' is the yearly profit. A higher profit will lead to a higher ROE. So, all else being equal, a high ROE is better than a low one. That means it can be interesting to compare the ROE of different companies.
Does Games Workshop Group 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, Games Workshop Group has a superior ROE than the average (12%) company in the Leisure industry.
That's clearly a positive. I usually take a closer look when a company has a better ROE than industry peers. One data point to check is if insiders have bought shares recently.
The Importance Of Debt To Return On Equity
Virtually all companies need money to invest in the business, to grow 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 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.
Games Workshop Group's Debt And Its 67% ROE
Shareholders will be pleased to learn that Games Workshop Group has not one iota of net debt! Its high ROE already points to a high quality business, but the lack of debt is a cherry on top. After all, when a company has a strong balance sheet, it can often find ways to invest in growth, even if it takes some time.
But It's Just One Metric
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. If two companies have around the same level of debt to equity, and one has a higher ROE, I'd generally prefer the one with higher ROE.
But when a business is high quality, the market often bids it up to a price that reflects this. 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.
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 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.
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