WH Smith PLC (LON:SMWH) Delivered A Better ROE Than Its Industry
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 WH Smith PLC (LON:SMWH), by way of a worked example.
Return on equity or ROE is an important factor to be considered by a shareholder because it tells them how effectively their capital is being reinvested. In short, ROE shows the profit each dollar generates with respect to its shareholder investments.
See our latest analysis for WH Smith
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 WH Smith is:
26% = UK£88m ÷ UK£340m (Based on the trailing twelve months to August 2023).
The 'return' is the amount earned after tax over the last twelve months. That means that for every £1 worth of shareholders' equity, the company generated £0.26 in profit.
Does WH Smith 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. Pleasingly, WH Smith has a superior ROE than the average (14%) in the Specialty Retail industry.
That is a good sign. Bear in mind, a high ROE doesn't always mean superior financial performance. Aside from changes in net income, a high ROE can also be the outcome of high debt relative to equity, which indicates risk.
How Does Debt Impact ROE?
Virtually all companies need money to invest in the business, to grow profits. That cash can come from retained earnings, issuing new shares (equity), 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.
Combining WH Smith's Debt And Its 26% Return On Equity
WH Smith does use a high amount of debt to increase returns. It has a debt to equity ratio of 1.13. While no doubt that its ROE is impressive, we would have been even more impressed had the company achieved this with lower debt. Investors should think carefully about how a company might perform if it was unable to borrow so easily, because credit markets do change over time.
Conclusion
Return on equity is useful for comparing the quality of different businesses. 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.
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 take a peek at this data-rich interactive graph of forecasts for the company.
Of course, you might find a fantastic investment by looking elsewhere. So take a peek at this free list of interesting companies.
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This article by Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. 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.
