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. We’ll use ROE to examine FMC Corporation (NYSE:FMC), by way of a worked example.
ROE or return on equity is a useful tool to assess how effectively a company can generate returns on the investment it received from its shareholders. In other words, it is a profitability ratio which measures the rate of return on the capital provided by the company’s shareholders.
How Is ROE Calculated?
The formula for ROE is:
Return on Equity = Net Profit (from continuing operations) ÷ Shareholders’ Equity
So, based on the above formula, the ROE for FMC is:
19% = US$579m ÷ US$3.0b (Based on the trailing twelve months to December 2020).
The ‘return’ is the income the business earned over the last year. So, this means that for every $1 of its shareholder’s investments, the company generates a profit of $0.19.
Does FMC Have A Good ROE?
By comparing a company’s ROE with its industry average, we can get a quick measure of how good it is. However, this method is only useful as a rough check, because companies do differ quite a bit within the same industry classification. As is clear from the image below, FMC has a better ROE than the average (10%) in the Chemicals industry.
That’s clearly a positive. With that said, a high ROE doesn’t always indicate high profitability. Aside from changes in net income, a high ROE can also be the outcome of high debt relative to equity, which indicates risk. Our risks dashboardshould have the 2 risks we have identified for FMC.
How Does Debt Impact ROE?
Most companies need money — from somewhere — to grow their profits. That cash can come from issuing shares, retained earnings, 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.
FMC’s Debt And Its 19% ROE
FMC clearly uses a high amount of debt to boost returns, as it has a debt to equity ratio of 1.10. There’s no doubt its ROE is decent, but the very high debt the company carries is not too exciting to see. 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.
Return on equity is useful for comparing the quality of different businesses. Companies that can achieve high returns on equity without too much debt are generally of good quality. If two companies have the same ROE, then I would generally prefer the one with less debt.
But ROE is just one piece of a bigger puzzle, since high quality businesses often trade on high multiples of earnings. 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 FMC 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.
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This article by Simply Wall St is general in nature. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any stocks mentioned.
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