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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 Pilgrim's Pride Corporation (NASDAQ:PPC), by way of a worked example.
Return on Equity or ROE is a test of how effectively a company is growing its value and managing investors’ money. In other words, it is a profitability ratio which measures the rate of return on the capital provided by the company's shareholders.
How To Calculate Return On Equity?
Return on equity can be calculated by using the formula:
Return on Equity = Net Profit (from continuing operations) ÷ Shareholders' Equity
So, based on the above formula, the ROE for Pilgrim's Pride is:
7.7% = US$187m ÷ US$2.4b (Based on the trailing twelve months to September 2020).
The 'return' is the amount earned after tax over the last twelve months. So, this means that for every $1 of its shareholder's investments, the company generates a profit of $0.08.
Does Pilgrim's Pride 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. However, this method is only useful as a rough check, because companies do differ quite a bit within the same industry classification. The image below shows that Pilgrim's Pride has an ROE that is roughly in line with the Food industry average (9.3%).
That isn't amazing, but it is respectable. Although the ROE is similar to the industry, we should still perform further checks to see if the company's ROE is being boosted by high debt levels. If so, this increases its exposure to financial risk. Our risks dashboardshould have the 3 risks we have identified for Pilgrim's Pride.
How Does Debt Impact Return On Equity?
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 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.
Combining Pilgrim's Pride's Debt And Its 7.7% Return On Equity
Pilgrim's Pride clearly uses a high amount of debt to boost returns, as it has a debt to equity ratio of 1.08. With a fairly low ROE, and significant use of debt, it's hard to get excited about this business at the moment. Debt does bring extra risk, so it's only really worthwhile when a company generates some decent returns from it.
Return on equity is one way we can compare its 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 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. The rate at which profits are likely to grow, relative to the expectations of profit growth reflected in the current price, must be considered, too. So I think it may be worth checking this free report on analyst forecasts for the company.
But note: Pilgrim's Pride 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.
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. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any stocks mentioned.
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