While some investors are already well versed in financial metrics (hat tip),neck and back clinic laveen 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 Best Buy Co., Inc. (

NYSE:BBY

), by way of a worked example.

Best Buy has a ROE of 36%

, based on the last twelve months. Another way to think of that is that for every $1 worth of equity in the company, it was able to earn $0.36.

See our latest analysis for Best Buy

How Do You Calculate Return On Equity?

The

formula for ROE

is:

Return on Equity = Net Profit ÷ Shareholders’ Equity

Or for Best Buy:

36% = 1093 ÷ US$3.0b (Based on the trailing twelve months to November 2018.)

Most know that net profit is the total earnings after all expenses, but the concept of shareholders’ equity is a little more complicated. It is all earnings retained by the company, plus any capital paid in by shareholders. Shareholders’ equity can be calculated by subtracting the total liabilities of the company from the total assets of the company.

What Does ROE Signify?

ROE measures a company’s profitability against the profit it retains, and any outside investments. The ‘return’ is the amount earned after tax over the last twelve months. That means that the higher the ROE, the more profitable the company is. So, as a general rule,

a high ROE is a good thing

. Clearly, then, one can use ROE to compare different companies.

Does Best Buy Have A Good Return On Equity?

By comparing a company’s ROE with its industry average, we can get a quick measure of how good it is. The limitation of this approach is that some companies are quite different from others, even within the same industry classification. Pleasingly, Best Buy has a superior ROE than the average (15%) company in the Specialty Retail industry.

NYSE:BBY Last Perf January 2nd 19

That is a good sign. I usually take a closer look when a company has a better ROE than industry peers. For example

you might check

if insiders are buying shares.

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 issuing shares, retained earnings, 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.

Best Buy’s Debt And Its 36% ROE

While Best Buy does have some debt, with debt to equity of just 0.45, we wouldn’t say debt is excessive. When I see a high ROE, fuelled by only modest debt, I suspect the business is high quality. Careful use of debt to boost returns is often very good for shareholders. However, it could reduce the company’s ability to take advantage of future opportunities.

Story continues

But It’s Just One Metric

Return on equity is one way we can compare the business quality of different companies. In my book the highest quality companies have high return on equity, despite low debt. 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.

Having said that, while ROE is a useful indicator of business quality, you’ll have to look at a whole range of factors to determine the right price to buy a stock. It is important to consider other factors, such as future profit growth — and how much investment is required going forward. So I think it may be worth checking this

free

report on analyst forecasts for the company

.

If you would prefer check out another company — one with potentially superior financials — then do not miss this

free

list of interesting companies, that have HIGH return on equity and low debt.

To help readers see past the short term volatility of the financial market, we aim to bring you a long-term focused research analysis purely driven by fundamental data. Note that our analysis does not factor in the latest price-sensitive company announcements.

The author is an independent contributor and at the time of publication had no position in the stocks mentioned. For errors that warrant correction please contact the editor at

[email protected]

.

View comments