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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 Inchcape plc (LON:INCH), 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.
Check out our latest analysis for Inchcape
How Is ROE Calculated?
The formula for return on equity is:
Return on Equity = Net Profit (from continuing operations) ÷ Shareholders' Equity
So, based on the above formula, the ROE for Inchcape is:
20% = UK£294m ÷ UK£1.5b (Based on the trailing twelve months to June 2024).
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 £0.20 in profit.
Does Inchcape Have A Good Return On Equity?
By comparing a company's ROE with its industry average, we can get a quick measure of how good it is. However, this method is only useful as a rough check, because companies do differ quite a bit within the same industry classification. As is clear from the image below, Inchcape has a better ROE than the average (9.7%) in the Retail Distributors industry.
That is a good sign. However, bear in mind that a high ROE doesn’t necessarily indicate efficient profit generation. A higher proportion of debt in a company's capital structure may also result in a high ROE, where the high debt levels could be a huge risk . To know the 2 risks we have identified for Inchcape visit our risks dashboard for free.
How Does Debt Impact Return On Equity?
Most companies need money -- from somewhere -- to grow their profits. That cash can come from issuing shares, retained earnings, 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 used for growth will improve returns, but won't affect the total equity. Thus the use of debt can improve ROE, albeit along with extra risk in the case of stormy weather, metaphorically speaking.
Inchcape's Debt And Its 20% ROE
It's worth noting the high use of debt by Inchcape, leading to its debt to equity ratio of 1.74. While its ROE is pretty respectable, the amount of debt the company is carrying currently is not ideal. 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.