While some investors are already familiar with financial metrics (hat tip), this article is for those who want to learn about return on equity (ROE) and its importance. As a real-world example, let’s look at National Research Corporation (NASDAQ:NRC) using ROE.
Return on equity or ROE is an important factor to be considered by a shareholder as it indicates how effectively their capital is being reinvested. In other words, this reveals that the company has been successful in turning shareholder investments into profits.
See our latest analysis from National Research.
How do you calculate return on equity?
Return on equity can be calculated using the following formula:
Return on equity = Net income (from continuing operations) ÷ Shareholders’ equity
So, based on the above formula, National Research’s ROE is:
73% = USD 29 million ÷ USD 40 million (based on trailing twelve months to June 2024).
“Revenue” is the income a company has earned over the past year. This means that for every $1 of shareholders’ equity, the company generated $0.73 in profit.
Is the ROE in the national survey good?
One easy way to determine whether a company has a high return on equity is to compare it to the average for its industry. Importantly, this is far from a perfect measure, as companies vary widely even within the same industry classification. We’re pleased to report that National Research’s ROE is better than the average (13%) in the Healthcare industry.
NasdaqGS:NRC Return on Equity (October 5, 2024)
That’s a good sign. However, a high ROE does not necessarily mean high profitability. Apart from changes in net income, a high ROE can also be a result of high debt relative to equity, which indicates risk. Our risk dashboard should include the three risks identified in National Research.
Why you need to consider debt when considering ROE
Most companies need money from somewhere to grow their profits. Cash for investments can come from previous years’ profits (retained earnings), issuing new shares, or borrowings. For the first and second options, ROE reflects the use of cash for growth. In the latter case, using debt increases returns but does not change equity. Thus, the use of debt can improve ROE even if the core economics of the business remain the same.
National Research’s debt and ROE of 73%
National Research clearly uses a significant amount of debt to generate profits, as it has a debt-to-equity ratio of 1.05. The ROE is pretty impressive, but it probably would have been lower if it didn’t have debt. Debt brings extra risk, so debt is only really worth it if a company generates some profit from it.
conclusion
Return on equity helps you compare the quality of different businesses. Companies that can achieve high returns on equity without taking on large amounts of debt are generally of good quality. All else being equal, a higher ROE is better.
However, ROE is only one piece of a larger puzzle, as high quality companies often trade at high multiples of earnings. You should also consider the rate at which earnings are likely to grow compared to the expected earnings growth reflected in the current price. So we think it might be worth checking out this free detailed graph of past earnings, revenue and cash flow.
Of course, you might find great investments if you look elsewhere. Take a peek at this free list of interesting companies.
Evaluation is complex, but we will simplify it here.
Discover whether National Research is undervalued or overvalued with an in-depth analysis featuring fair value estimates, potential risks, dividends, insider transactions, and financial condition.
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This article by Simply Wall St is general in nature. We provide commentary using only unbiased methodologies, based on historical data and analyst forecasts, and articles are not intended to be financial advice. This is not a recommendation to buy or sell any stock, and does not take into account your objectives or financial situation. We aim to provide long-term, focused analysis based on fundamental data. Note that our analysis may not factor in the latest announcements or qualitative material from price-sensitive companies. Simply Wall St has no position in any stocks mentioned.
