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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 J D Wetherspoon plc (LON:JDW), by way of a worked example.
Return on Equity or ROE is a test of how effectively a company is growing its value and managing investors’ money. Put another way, it reveals the company's success at turning shareholder investments into profits.
See our latest analysis for J D Wetherspoon
How Do You Calculate Return On Equity?
ROE can be calculated by using the formula:
Return on Equity = Net Profit (from continuing operations) ÷ Shareholders' Equity
So, based on the above formula, the ROE for J D Wetherspoon is:
12% = UK£49m ÷ UK£402m (Based on the trailing twelve months to July 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 £0.12 in profit.
Does J D Wetherspoon Have A Good ROE?
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, J D Wetherspoon has a better ROE than the average (7.9%) in the Hospitality 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 . You can see the 2 risks we have identified for J D Wetherspoon by visiting our risks dashboard for free on our platform here.
How Does Debt Impact Return On Equity?
Virtually all companies need money to invest in the business, to grow profits. The cash for investment can come from prior year profits (retained earnings), issuing new shares, or borrowing. 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. Thus the use of debt can improve ROE, albeit along with extra risk in the case of stormy weather, metaphorically speaking.
Combining J D Wetherspoon's Debt And Its 12% Return On Equity
J D Wetherspoon clearly uses a high amount of debt to boost returns, as it has a debt to equity ratio of 1.80. While its ROE is respectable, it is worth keeping in mind that there is usually a limit as to how much debt a company can use. Debt increases risk and reduces options for the company in the future, so you generally want to see some good returns from using it.