While some investors are already familiar with financial metrics (hat trick), this article is for those who want to learn more about return on equity (ROE) and why it matters. We’ll use ROE to look at Carriage Services, Inc. (NYSE:CSV), as a real-life example.
ROE or return on equity is a useful tool for evaluating how effectively a company can generate returns on the investment it has received from its shareholders. In other words, it is a profitability ratio that measures the rate of return on capital contributed by the company’s shareholders.
Check out our latest analysis for transportation services
How is ROE calculated?
the ROE formula is:
Return on equity = Net income (from continuing operations) ÷ Equity
So, based on the formula above, the ROE for transportation services is:
15% = $28 million ÷ $192 million (based on trailing 12 months to September 2021).
The “return” is the annual profit. One way to conceptualize this is that for every $1 of share capital it has, the firm has made a profit of $0.15.
Do transportation services have a good ROE?
By comparing a company’s ROE with the average for its industry, we can get a quick measure of its quality. However, this method is only useful as a rough check, as companies differ quite a bit within the same industry classification. Fortunately, transportation services have an above-average ROE (8.7%) for the consumer services industry.
It’s a good sign. However, keep in mind that a high ROE does not necessarily indicate efficient profit generation. A higher proportion of debt in a company’s capital structure can also result in a high ROE, where high debt levels could be a huge risk. Our risk dashboard should contain the 2 risks we have identified for transport services.
Why You Should Consider Debt When Looking at ROE
Companies generally need to invest money to increase their profits. This money can come from issuing shares, retained earnings or debt. In the first and second case, the ROE will reflect this use of cash for investment in the business. In the latter case, debt used for growth will enhance returns, but will not affect total equity. So using debt can improve ROE, but with the added risk of stormy weather, metaphorically speaking.
Carriage Services’ debt and its ROE of 15%
Of note is Carriage Services’ high reliance on debt, which led to its debt-to-equity ratio of 2.52. Although its ROE is quite respectable, the amount of debt the company is currently carrying is not ideal. Debt increases risk and reduces options for the business in the future, so you generally want to see good returns using it.
Return on equity is a way to compare the business quality of different companies. A company that can earn a high return on equity without going into debt could be considered a high quality company. All things being equal, a higher ROE is better.
That said, while ROE is a useful indicator of a company’s quality, you’ll need to consider a whole host of factors to determine the right price to buy a stock. Earnings growth rates, relative to expectations reflected in the share price, are particularly important to consider. You might want to take a look at this data-rich interactive chart of the company’s forecast.
If you’d rather check out another company – one with potentially superior finances – then don’t miss this free list of attractive companies, which have a high return on equity and low debt.
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This Simply Wall St article is general in nature. We provide commentary based on historical data and analyst forecasts only using unbiased methodology and our articles are not intended to be financial advice. It is not a recommendation to buy or sell stocks and does not take into account your objectives or financial situation. Our goal is to bring you targeted long-term analysis based on fundamental data. Note that our analysis may not take into account the latest announcements from price-sensitive companies or qualitative materials. Simply Wall St has no position in the stocks mentioned.