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Should Inchcape plc (LON:INCH) Focus On Improving This Fundamental Metric?

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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. By way of learning-by-doing, we'll look at ROE to gain a better understanding of Inchcape plc (LON:INCH).

Over the last twelve months Inchcape has recorded a ROE of 3.9%. One way to conceptualize this, is that for each £1 of shareholders' equity it has, the company made £0.039 in profit.

View our latest analysis for Inchcape

How Do I Calculate Return On Equity?

The formula for return on equity is:

Return on Equity = Net Profit ÷ Shareholders' Equity

Or for Inchcape:

3.9% = UK£48m ÷ UK£1.4b (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 earnings retained by the company, plus any capital paid in by shareholders. You can calculate shareholders' equity by subtracting the company's total liabilities from its total assets.

What Does Return On Equity Signify?

ROE looks at the amount a company earns relative to the money it has kept within the business. The 'return' is the profit 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. That means it can be interesting to compare the ROE of different companies.

Does Inchcape Have A Good Return On Equity?

One simple way to determine if a company has a good return on equity is to compare it to the average for its industry. However, this method is only useful as a rough check, because companies do differ quite a bit within the same industry classification. As shown in the graphic below, Inchcape has a lower ROE than the average (12%) in the Retail Distributors industry classification.

LSE:INCH Past Revenue and Net Income, July 1st 2019
LSE:INCH Past Revenue and Net Income, July 1st 2019

That certainly isn't ideal. We'd prefer see an ROE above the industry average, but it might not matter if the company is undervalued. Nonetheless, it might be wise to check if insiders have been selling.

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 first and second cases, the ROE will reflect this use of cash for investment in the business. In the latter case, the debt required for growth will boost returns, but will not impact the shareholders' equity. In this manner the use of debt will boost ROE, even though the core economics of the business stay the same.

Combining Inchcape's Debt And Its 3.9% Return On Equity

It's worth noting the significant use of debt by Inchcape, leading to its debt to equity ratio of 1.59. Its ROE isn't too bad, but it would probably be very disappointing if the company had to stop using debt. 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 one way we can compare the business quality of different companies. Companies that can achieve high returns on equity without too much debt are generally of good quality. If two companies have the same ROE, then I would generally prefer the one with less debt.

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. Profit growth rates, versus the expectations reflected in the price of the stock, are a particularly important to consider. So I think it may be worth checking this free report on analyst forecasts for the company.

Of course Inchcape 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 editorial-team@simplywallst.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. Thank you for reading.

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