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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 Fevertree Drinks Plc (LON:FEVR), by way of a worked example.
Over the last twelve months Fevertree Drinks has recorded a ROE of 32%. One way to conceptualize this, is that for each £1 of shareholders' equity it has, the company made £0.32 in profit.
View our latest analysis for Fevertree Drinks
How Do I Calculate ROE?
The formula for ROE is:
Return on Equity = Net Profit ÷ Shareholders' Equity
Or for Fevertree Drinks:
32% = UK£64m ÷ UK£201m (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 the capital paid in by shareholders, plus any retained earnings. The easiest way to calculate shareholders' equity is to subtract the company's total liabilities from the total assets.
What Does ROE Signify?
Return on Equity measures a company's profitability against the profit it has kept for the business (plus any capital injections). The 'return' is the yearly profit. The higher the ROE, the more profit the company is making. So, all else equal, investors should like a high ROE. That means it can be interesting to compare the ROE of different companies.
Does Fevertree Drinks Have A Good Return On Equity?
One simple way to determine if a company has a good return on equity is to compare it to the average for its industry. However, this method is only useful as a rough check, because companies do differ quite a bit within the same industry classification. Pleasingly, Fevertree Drinks has a superior ROE than the average (18%) company in the Beverage industry.
That's clearly a positive. I usually take a closer look when a company has a better ROE than industry peers. For example you might check if insiders are buying shares.
How Does Debt Impact ROE?
Most companies need money -- from somewhere -- to grow their profits. That cash can come from issuing shares, retained earnings, or debt. In the first two cases, the ROE will capture this use of capital to grow. 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 Fevertree Drinks's Debt And Its 32% Return On Equity
One positive for shareholders is that Fevertree Drinks does not have any net debt! Its high ROE indicates the business is high quality, but the fact that this was achieved without leverage is veritably impressive. At the end of the day, when a company has zero debt, it is in a better position to take future growth opportunities.