While some investors are already well versed in financial metrics (hat tip), this article is for those who would like to learn about Return On Equity (ROE) and why it is important. We’ll use ROE to examine National Retail Properties, Inc. (NYSE:NNN), by way of a worked example.
National Retail Properties has a ROE of 7.0%, based on the last twelve months. One way to conceptualize this, is that for each $1 of shareholders’ equity it has, the company made $0.070 in profit.
How Do You Calculate Return On Equity?
The formula for return on equity is:
Return on Equity = Net Profit ÷ Shareholders’ Equity
Or for National Retail Properties:
7.0% = US$258m ÷ US$4.2b (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. Shareholders’ equity can be calculated by subtracting the total liabilities of the company from the total assets of the company.
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 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. Clearly, then, one can use ROE to compare different companies.
Does National Retail Properties Have A Good ROE?
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. If you look at the image below, you can see National Retail Properties has a similar ROE to the average in the REITs industry classification (6.6%).
That’s not overly surprising. ROE doesn’t tell us if the share price is low, but it can inform us to the nature of the business. For those looking for a bargain, other factors may be more important. I will like National Retail Properties better if I see some big insider buys. While we wait, check out this free list of growing companies with considerable, recent, insider buying.
How Does Debt Impact ROE?
Most companies need money — from somewhere — to grow their profits. The cash for investment can come from prior year profits (retained earnings), issuing new shares, or borrowing. In the first two cases, the ROE will capture this use of capital to grow. In the latter case, the debt required for growth will boost returns, but will not impact the shareholders’ equity. That will make the ROE look better than if no debt was used.
National Retail Properties’s Debt And Its 7.0% ROE
While National Retail Properties does have some debt, with debt to equity of just 0.69, we wouldn’t say debt is excessive. I’m not impressed with its ROE, but the debt levels are not too high, indicating the business has decent prospects. 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 Key Takeaway
Return on equity is one way we can compare the business quality of different companies. 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 when a business is high quality, the market often bids it up to a price that reflects this. 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.
Of course National Retail Properties 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.
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