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One of the best investments we can make is in our own knowledge and skill set. With that in mind, this article will work through how we can use Return On Equity (ROE) to better understand a business. To keep the lesson grounded in practicality, we’ll use ROE to better understand ASGN Incorporated (NYSE:ASGN).
ASGN has a ROE of 13%, based on the last twelve months. That means that for every $1 worth of shareholders’ equity, it generated $0.13 in profit.
How Do I Calculate Return On Equity?
The formula for ROE is:
Return on Equity = Net Profit ÷ Shareholders’ Equity
Or for ASGN:
13% = 157.984 ÷ US$1.2b (Based on the trailing twelve months to December 2018.)
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 Signify?
ROE measures a company’s profitability against the profit it retains, and any outside investments. The ‘return’ is the amount earned after tax over the last twelve months. The higher the ROE, the more profit the company is making. So, all else being equal, a high ROE is better than a low one. Clearly, then, one can use ROE to compare different companies.
Does ASGN Have A Good Return On Equity?
By comparing a company’s ROE with its industry average, we can get a quick measure of how good it is. Importantly, this is far from a perfect measure, because companies differ significantly within the same industry classification. Pleasingly, ASGN has a superior ROE than the average (11%) company in the Professional Services industry.
That’s what I like to see. We think a high ROE, alone, is usually enough to justify further research into a company. For example you might check if insiders are buying shares.
Why You Should Consider Debt When Looking At ROE
Most companies need money — from somewhere — to grow their profits. That cash can come from issuing shares, retained earnings, or debt. In the first two cases, the ROE will capture this use of capital to grow. In the latter case, the use of debt will improve the returns, but will not change the equity. In this manner the use of debt will boost ROE, even though the core economics of the business stay the same.
ASGN’s Debt And Its 13% ROE
Although ASGN does use debt, its debt to equity ratio of 0.93 is still low. The combination of modest debt and a very respectable ROE suggests this is a business worth watching. Careful use of debt to boost returns is often very good for shareholders. However, it could reduce the company’s ability to take advantage of future opportunities.
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 around the same level of debt to equity, and one has a higher ROE, I’d generally prefer the one with higher ROE.
But ROE is just one piece of a bigger puzzle, since high quality businesses often trade on high multiples of earnings. It is important to consider other factors, such as future profit growth — and how much investment is required going forward. 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 this free list of interesting companies, that have HIGH return on equity 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. On rare occasion, data errors may occur. Thank you for reading.