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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 Arko Corp. (NASDAQ:ARKO), by way of a worked example.
Return on equity or ROE is a key measure used to assess how efficiently a company's management is utilizing the company's capital. In short, ROE shows the profit each dollar generates with respect to its shareholder investments.
See our latest analysis for Arko
How Do You Calculate Return On Equity?
The formula for return on equity is:
Return on Equity = Net Profit (from continuing operations) ÷ Shareholders' Equity
So, based on the above formula, the ROE for Arko is:
6.4% = US$24m ÷ US$380m (Based on the trailing twelve months to September 2024).
The 'return' is the profit over the last twelve months. So, this means that for every $1 of its shareholder's investments, the company generates a profit of $0.06.
Does Arko 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. If you look at the image below, you can see Arko has a lower ROE than the average (20%) in the Specialty Retail industry classification.
Unfortunately, that's sub-optimal. That being said, a low ROE is not always a bad thing, especially if the company has low leverage as this still leaves room for improvement if the company were to take on more debt. When a company has low ROE but high debt levels, we would be cautious as the risk involved is too high. Our risks dashboard should have the 2 risks we have identified for Arko.
The Importance Of Debt To Return On Equity
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 case of the first and second options, the ROE will reflect this use of cash, for growth. In the latter case, the use of debt will improve the returns, but will not change the equity. Thus the use of debt can improve ROE, albeit along with extra risk in the case of stormy weather, metaphorically speaking.
Arko's Debt And Its 6.4% ROE
Arko does use a high amount of debt to increase returns. It has a debt to equity ratio of 2.33. The combination of a rather low ROE and significant use of debt is not particularly appealing. Investors should think carefully about how a company might perform if it was unable to borrow so easily, because credit markets do change over time.