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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. We'll use ROE to examine The Scotts Miracle-Gro Company (NYSE:SMG), 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.
View our latest analysis for Scotts Miracle-Gro
How Do You Calculate Return On Equity?
Return on equity 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 Scotts Miracle-Gro is:
42% = US$408m ÷ US$975m (Based on the trailing twelve months to April 2022).
The 'return' is the yearly profit. That means that for every $1 worth of shareholders' equity, the company generated $0.42 in profit.
Does Scotts Miracle-Gro Have A Good ROE?
One simple way to determine if a company has a good return on equity is to compare it to the average for its industry. Importantly, this is far from a perfect measure, because companies differ significantly within the same industry classification. Pleasingly, Scotts Miracle-Gro has a superior ROE than the average (17%) in the Chemicals industry.
That's what we like to see. With that said, a high ROE doesn't always indicate high profitability. Aside from changes in net income, a high ROE can also be the outcome of high debt relative to equity, which indicates risk. Our risks dashboardshould have the 4 risks we have identified for Scotts Miracle-Gro.
How Does Debt Impact 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 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. That will make the ROE look better than if no debt was used.
Combining Scotts Miracle-Gro's Debt And Its 42% Return On Equity
It appears that Scotts Miracle-Gro makes extensive use of debt to improve its returns, because it has an alarmingly high debt to equity ratio of 3.88. Its ROE is clearly quite good, but it seems to be boosted by the significant use of debt by the company.
Conclusion
Return on equity is one way we can compare its business quality of different companies. A company that can achieve a high return on equity without debt could be considered a high quality business. If two companies have around the same level of debt to equity, and one has a higher ROE, I'd generally prefer the one with higher ROE.