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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. By way of learning-by-doing, we'll look at ROE to gain a better understanding of Matthews International Corporation (NASDAQ:MATW).
Over the last twelve months Matthews International has recorded a ROE of 8.5%. One way to conceptualize this, is that for each $1 of shareholders' equity it has, the company made $0.085 in profit.
Check out our latest analysis for Matthews International
How Do I Calculate ROE?
The formula for return on equity is:
Return on Equity = Net Profit ÷ Shareholders' Equity
Or for Matthews International:
8.5% = US$73m ÷ US$847m (Based on the trailing twelve months to March 2019.)
It's easy to understand the 'net profit' part of that equation, but 'shareholders' equity' requires further explanation. It is all earnings retained by the company, plus any capital paid in by shareholders. Shareholders' equity can be calculated by subtracting the total liabilities of the company from the total assets of the company.
What Does ROE Mean?
ROE looks at the amount a company earns relative to the money it has kept within the business. The 'return' is the profit over the last twelve months. A higher profit will lead to a higher ROE. So, all else being equal, a high ROE is better than a low one. That means ROE can be used to compare two businesses.
Does Matthews International Have A Good ROE?
Arguably the easiest way to assess company's ROE is to compare it with the average in its industry. The limitation of this approach is that some companies are quite different from others, even within the same industry classification. As shown in the graphic below, Matthews International has a lower ROE than the average (13%) in the Commercial Services industry classification.
That's not what we like to see. We'd prefer see an ROE above the industry average, but it might not matter if the company is undervalued. Still, shareholders might want to check if insiders have been selling.
How Does Debt Impact Return On Equity?
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 two cases, the ROE will capture this use of capital to grow. In the latter case, the use of debt will improve the returns, but will not change the equity. In this manner the use of debt will boost ROE, even though the core economics of the business stay the same.