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One of the best investments we can make is in our own knowledge and skill set. With that in mind, this article will work through how we can use Return On Equity (ROE) to better understand a business. We'll use ROE to examine Collegium Pharmaceutical, Inc. (NASDAQ:COLL), 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 short, ROE shows the profit each dollar generates with respect to its shareholder investments.
How Is ROE Calculated?
The formula for ROE is:
Return on Equity = Net Profit (from continuing operations) ÷ Shareholders' Equity
So, based on the above formula, the ROE for Collegium Pharmaceutical is:
30% = US$69m ÷ US$229m (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 $0.30 in profit.
Check out our latest analysis for Collegium Pharmaceutical
Does Collegium Pharmaceutical 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. The limitation of this approach is that some companies are quite different from others, even within the same industry classification. As is clear from the image below, Collegium Pharmaceutical has a better ROE than the average (21%) in the Pharmaceuticals industry.
That's clearly a positive. 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. You can see the 3 risks we have identified for Collegium Pharmaceutical by visiting our risks dashboard for free on our platform here.
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 used for growth will improve returns, but won't affect the total equity. That will make the ROE look better than if no debt was used.
Collegium Pharmaceutical's Debt And Its 30% ROE
It appears that Collegium Pharmaceutical makes extensive use of debt to improve its returns, because it has an alarmingly high debt to equity ratio of 4.25. So although the company has an impressive ROE, the company might not have been able to achieve this without the significant use of debt.