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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). By way of learning-by-doing, we'll look at ROE to gain a better understanding of J D Wetherspoon plc (LON:JDW).
Return on equity or ROE is a key measure used to assess how efficiently a company's management is utilizing the company's capital. Simply put, it is used to assess the profitability of a company in relation to its equity capital.
See our latest analysis for J D Wetherspoon
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 J D Wetherspoon is:
18% = UK£68m ÷ UK£384m (Based on the trailing twelve months to January 2023).
The 'return' is the amount earned after tax over the last twelve months. Another way to think of that is that for every £1 worth of equity, the company was able to earn £0.18 in profit.
Does J D Wetherspoon 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. Importantly, this is far from a perfect measure, because companies differ significantly within the same industry classification. As is clear from the image below, J D Wetherspoon has a better ROE than the average (12%) in the Hospitality industry.
That's clearly a positive. With that said, a high ROE doesn't always indicate high profitability. Especially when a firm uses high levels of debt to finance its debt which may boost its ROE but the high leverage puts the company at risk. You can see the 2 risks we have identified for J D Wetherspoon by visiting our risks dashboard for free on our platform here.
The Importance Of Debt To 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 first two cases, the ROE will capture this use of capital to grow. 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.
J D Wetherspoon's Debt And Its 18% ROE
J D Wetherspoon does use a high amount of debt to increase returns. It has a debt to equity ratio of 2.07. While its ROE is pretty respectable, the amount of debt the company is carrying currently is not ideal. Debt increases risk and reduces options for the company in the future, so you generally want to see some good returns from using it.