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 Packaging Corporation of America (NYSE:PKG), by way of a worked example.
Our data shows Packaging Corporation of America has a return on equity of 27% for the last year. Another way to think of that is that for every $1 worth of equity in the company, it was able to earn $0.27.
How Do I Calculate Return On Equity?
The formula for ROE is:
Return on Equity = Net Profit ÷ Shareholders' Equity
Or for Packaging Corporation of America:
27% = US$786m ÷ US$2.9b (Based on the trailing twelve months to June 2019.)
Most readers would understand what net profit is, but it’s worth explaining the concept of shareholders’ equity. 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 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. A higher profit will lead to a higher ROE. So, all else equal, investors should like a high ROE. That means ROE can be used to compare two businesses.
Does Packaging Corporation of America 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. As you can see in the graphic below, Packaging Corporation of America has a higher ROE than the average (16%) in the Packaging industry.
That is a good sign. We think a high ROE, alone, is usually enough to justify further research into a company. One data point to check is if insiders have bought shares recently.
How Does Debt Impact ROE?
Companies usually need to invest money to grow their profits. The cash for investment can come from prior year profits (retained earnings), issuing new shares, or borrowing. In the case of the first and second options, the ROE will reflect this use of cash, for growth. 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.
Packaging Corporation of America's Debt And Its 27% ROE
While Packaging Corporation of America does have some debt, with debt to equity of just 0.85, we wouldn't say debt is excessive. Its ROE is very impressive, and given only modest debt, this suggests the business is high quality. Judicious use of debt to improve returns can certainly be a good thing, although it does elevate risk slightly and reduce future optionality.
Return on equity is a useful indicator of the ability of a business to generate profits and return them to shareholders. Companies that can achieve high returns on equity without too much debt are generally of good quality. 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. It is important to consider other factors, such as future profit growth -- and how much investment is required going forward. So you might want to check this FREE visualization of analyst forecasts for the company.
Of course Packaging Corporation of America 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 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. Thank you for reading.