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. We'll use ROE to examine The Wendy's Company (NASDAQ:WEN), by way of a worked example.
ROE or return on equity is a useful tool to assess how effectively a company can generate returns on the investment it received from its shareholders. Put another way, it reveals the company's success at turning shareholder investments into profits.
View our latest analysis for Wendy's
How To 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 Wendy's is:
49% = US$191m ÷ US$391m (Based on the trailing twelve months to July 2023).
The 'return' is the yearly profit. One way to conceptualize this is that for each $1 of shareholders' capital it has, the company made $0.49 in profit.
Does Wendy's 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, Wendy's has a better ROE than the average (17%) in the Hospitality industry.
That's what we like to see. Bear in mind, a high ROE doesn't always mean superior financial performance. 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 . Our risks dashboardshould have the 2 risks we have identified for Wendy's.
Why You Should Consider Debt When Looking At ROE
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 case of the first and second options, the ROE will reflect this use of cash, for growth. 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 Wendy's' Debt And Its 49% Return On Equity
We think Wendy's uses a significant amount of debt to maximize its returns, as it has a significantly higher debt to equity ratio of 7.19. Its ROE is clearly quite good, but it seems to be boosted by the significant use of debt by the company.