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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. To keep the lesson grounded in practicality, we'll use ROE to better understand Emerson Electric Co. (NYSE:EMR).
Over the last twelve months Emerson Electric has recorded a ROE of 25%. One way to conceptualize this, is that for each $1 of shareholders' equity it has, the company made $0.25 in profit.
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How Do You Calculate Return On Equity?
The formula for return on equity is:
Return on Equity = Net Profit ÷ Shareholders' Equity
Or for Emerson Electric:
25% = US$2.2b ÷ US$8.8b (Based on the trailing twelve months to June 2019.)
It's easy to understand the 'net profit' part of that equation, but 'shareholders' equity' requires further explanation. It is all the money paid into the company from shareholders, plus any earnings retained. You can calculate shareholders' equity by subtracting the company's total liabilities from its total assets.
What Does ROE Signify?
ROE measures a company's profitability against the profit it retains, and any outside investments. The 'return' is the yearly profit. A higher profit will lead to a higher ROE. So, all else equal, investors should like a high ROE. That means ROE can be used to compare two businesses.
Does Emerson Electric Have A Good Return On Equity?
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 you can see in the graphic below, Emerson Electric has a higher ROE than the average (14%) in the Electrical industry.
That's what I like to see. I usually take a closer look when a company has a better ROE than industry peers. One data point to check is if insiders have bought shares recently.
The Importance Of Debt To Return On Equity
Companies usually need to invest money to grow their profits. That cash can come from retained earnings, issuing new shares (equity), or debt. 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 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.
Emerson Electric's Debt And Its 25% ROE
Although Emerson Electric does use debt, its debt to equity ratio of 0.71 is still low. Its ROE is very impressive, and given only modest debt, this suggests the business is high quality. Careful use of debt to boost returns is often very good for shareholders. However, it could reduce the company's ability to take advantage of future opportunities.