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 Lok'nStore Group Plc (LON:LOK), by way of a worked example.
Lok'nStore Group has a ROE of 2.9%, based on the last twelve months. One way to conceptualize this, is that for each £1 of shareholders' equity it has, the company made £0.03 in profit.
How Do You Calculate ROE?
The formula for return on equity is:
Return on Equity = Net Profit (from continuing operations) ÷ Shareholders' Equity
Or for Lok'nStore Group:
2.9% = UK£3.4m ÷ UK£117m (Based on the trailing twelve months to July 2019.)
It's easy to understand the 'net profit' part of that equation, but 'shareholders' equity' requires further explanation. 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 Mean?
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. 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 ROE can be used to compare two businesses.
Does Lok'nStore Group Have A Good ROE?
Arguably the easiest way to assess company's ROE is to compare it with the average in its industry. The limitation of this approach is that some companies are quite different from others, even within the same industry classification. If you look at the image below, you can see Lok'nStore Group has a lower ROE than the average (9.5%) in the Real Estate industry classification.
That certainly isn't ideal. We prefer it when the ROE of a company is above the industry average, but it's not the be-all and end-all if it is lower. Nonetheless, it might be wise to check if insiders have been selling.
The Importance Of Debt To Return On Equity
Most companies need money -- from somewhere -- 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. Thus the use of debt can improve ROE, albeit along with extra risk in the case of stormy weather, metaphorically speaking.
Lok'nStore Group's Debt And Its 2.9% ROE
Although Lok'nStore Group does use debt, its debt to equity ratio of 0.36 is still low. Its ROE isn't particularly impressive, but the debt levels are quite modest, so the business probably has some real potential. 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.
The Bottom Line On ROE
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. 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. Profit growth rates, versus the expectations reflected in the price of the stock, are a particularly important to consider. So you might want to check this FREE visualization of 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 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.
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