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While some investors are already well versed in financial metrics (hat tip), this article is for those who would like to learn about Return On Equity (ROE) and why it is important.
By way of learning-by-doing, we’ll look at ROE to gain a better understanding of Evolution Petroleum Corporation (NYSEMKT:EPM).
Evolution Petroleum has a ROE of 21%, based on the last twelve months.
One way to conceptualize this, is that for each $1 of shareholders’ equity it has, the company made $0.21 in profit.
How Do You Calculate ROE?
The formula for return on equity is:
Return on Equity = Net Profit ÷ Shareholders’ Equity
Or for Evolution Petroleum:
21% = 17.30147 ÷ US$81m (Based on the trailing twelve months to December 2018.)
Most readers would understand what net profit is, but it’s worth explaining the concept of shareholders’ equity.
It is the capital paid in by shareholders, plus any retained earnings.
Shareholders’ equity can be calculated by subtracting the total liabilities of the company from the total assets of the company.
What Does Return On Equity Mean?
ROE looks at the amount a company earns relative to the money it has kept within the business.
The ‘return’ is the yearly profit.
A higher profit will lead to a higher ROE.
So, all else equal, investors should like a high ROE.
That means ROE can be used to compare two businesses.
Does Evolution Petroleum Have A Good ROE?
One simple way to determine if a company has a good return on equity is to compare it to the average for its industry.
The limitation of this approach is that some companies are quite different from others, even within the same industry classification.
As is clear from the image below, Evolution Petroleum has a better ROE than the average (12%) in the Oil and Gas industry.
That’s clearly a positive.
In my book, a high ROE almost always warrants a closer look.
For example, I often check if insiders have been buying shares .
How Does Debt Impact 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 use of debt will improve the returns, but will not change the equity.
That will make the ROE look better than if no debt was used.
Combining Evolution Petroleum’s Debt And Its 21% Return On Equity
Evolution Petroleum is free of net debt, which is a positive for shareholders.
Its respectable ROE suggests it is a business worth watching, but it’s even better the company achieved this without leverage.
After all, when a company has a strong balance sheet, it can often find ways to invest in growth, even if it takes some time.
The Key Takeaway
Return on equity is a useful indicator of the ability of a business to generate profits and return them to shareholders.
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.
Profit growth rates, versus the expectations reflected in the price of the stock, are a particularly important to consider.
So you might want to take a peek at this data-rich interactive graph of forecasts for the company.
Of course Evolution Petroleum may not be the best stock to buy. So you may wish to see this free collection of other companies that have high ROE 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 firstname.lastname@example.org.
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