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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 Veralto Corporation (NYSE:VLTO), by way of a worked example.
Return on equity or ROE is a key measure used to assess how efficiently a company's management is utilizing the company's capital. In simpler terms, it measures the profitability of a company in relation to shareholder's equity.
View our latest analysis for Veralto
How Do You 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 Veralto is:
41% = US$833m ÷ US$2.0b (Based on the trailing twelve months to December 2024).
The 'return' refers to a company's earnings over the last year. Another way to think of that is that for every $1 worth of equity, the company was able to earn $0.41 in profit.
Does Veralto 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. 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, Veralto has a higher ROE than the average (13%) in the Commercial Services industry.
That is a good sign. However, bear in mind that a high ROE doesn’t necessarily indicate efficient profit generation. Aside from changes in net income, a high ROE can also be the outcome of high debt relative to equity, which indicates risk.
Why You Should Consider Debt When Looking At 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 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. In this manner the use of debt will boost ROE, even though the core economics of the business stay the same.
Combining Veralto's Debt And Its 41% Return On Equity
It's worth noting the high use of debt by Veralto, leading to its debt to equity ratio of 1.27. Its ROE is pretty impressive but, it would have probably been lower without the use of 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.