In This Article:
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. By way of learning-by-doing, we’ll look at ROE to gain a better understanding Watsco Inc (NYSE:WSO).
Over the last twelve months Watsco has recorded a ROE of 18%. That means that for every $1 worth of shareholders’ equity, it generated $0.18 in profit.
See our latest analysis for Watsco
How Do I Calculate ROE?
The formula for return on equity is:
Return on Equity = Net Profit ÷ Shareholders’ Equity
Or for Watsco:
18% = US$213m ÷ US$1.6b (Based on the trailing twelve months to June 2018.)
It’s easy to understand the ‘net profit’ part of that equation, but ‘shareholders’ equity’ requires further explanation. It is all the money paid into the company from shareholders, plus any earnings retained. The easiest way to calculate shareholders’ equity is to subtract the company’s total liabilities from the total assets.
What Does ROE Signify?
ROE looks at the amount a company earns relative to the money it has kept within the business. The ‘return’ is the profit over the last twelve months. A higher profit will lead to a a higher ROE. So, as a general rule, a high ROE is a good thing. That means ROE can be used to compare two businesses.
Does Watsco Have A Good ROE?
Arguably the easiest way to assess company’s ROE is to compare it with the average in its industry. The limitation of this approach is that some companies are quite different from others, even within the same industry classification. As you can see in the graphic below, Watsco has a higher ROE than the average (13%) in the trade distributors industry.
That’s clearly a positive. I usually take a closer look when a company has a better ROE than industry peers. For example, I often check if insiders have been buying shares .
Why You Should Consider Debt When Looking At ROE
Virtually all companies need money to invest in the business, to grow profits. That cash can come from retained earnings, issuing new shares (equity), or debt. In the first and second cases, the ROE will reflect this use of cash for investment in the business. 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.
Watsco’s Debt And Its 18% ROE
Although Watsco does use a little debt, its debt to equity ratio of just 0.09 is very low. Its very respectable ROE, combined with only modest debt, suggests the business is in good shape. Conservative use of debt to boost returns is usually a good move for shareholders, though it does leave the company more exposed to interest rate rises.