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. To keep the lesson grounded in practicality, we'll use ROE to better understand Physicians Realty Trust (NYSE:DOC).
Physicians Realty Trust has a ROE of 1.8%, based on the last twelve months. That means that for every $1 worth of shareholders' equity, it generated $0.02 in profit.
How Do I Calculate ROE?
The formula for return on equity is:
Return on Equity = Net Profit (from continuing operations) ÷ Shareholders' Equity
Or for Physicians Realty Trust:
1.8% = US$46m ÷ US$2.5b (Based on the trailing twelve months to September 2019.)
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 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 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 amount earned after tax over the last twelve months. A higher profit will lead to a higher ROE. So, as a general rule, a high ROE is a good thing. That means it can be interesting to compare the ROE of different companies.
Does Physicians Realty Trust 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. 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 Physicians Realty Trust has a lower ROE than the average (5.9%) in the REITs industry classification.
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 could be useful to double-check if insiders have sold shares recently.
How Does Debt Impact Return On Equity?
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 case of the first and second options, the ROE will reflect this use of cash, for growth. In the latter case, the debt used for growth will improve returns, but won't affect the total equity. Thus the use of debt can improve ROE, albeit along with extra risk in the case of stormy weather, metaphorically speaking.
Physicians Realty Trust's Debt And Its 1.8% ROE
While Physicians Realty Trust does have some debt, with debt to equity of just 0.63, we wouldn't say debt is excessive. Its ROE is certainly on the low side, and since it already uses debt, we're not too excited about the company. Judicious use of debt to improve returns can certainly be a good thing, although it does elevate risk slightly and reduce future optionality.
The Key Takeaway
Return on equity is one way we can compare the business quality of different companies. A company that can achieve a high return on equity without debt could be considered a high quality business. 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.
But note: Physicians Realty Trust may not be the best stock to buy. So take a peek at this free list of interesting companies with high ROE 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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