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. Learning by doing, we will look at ROE to better understand Dr. Martens plc (LON:DOCS).
Return on equity or ROE is an important factor for a shareholder to consider as it tells them how much of their capital is being reinvested. In simpler terms, it measures a company’s profitability relative to equity.
Check out our latest analysis for Dr. Martens
How is ROE calculated?
Return on equity can be calculated using the formula:
Return on equity = Net income (from continuing operations) ÷ Equity
So, based on the above formula, the ROE for Dr. Martens is:
27% = £55m ÷ £204m (based on trailing 12 months to September 2021).
The “yield” is the profit of the last twelve months. Another way to think about this is that for every £1 of equity, the company was able to make a profit of £0.27.
Does Dr. Martens have a good return on equity?
A 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 industrial classification. You can see from the graph below that Dr. Martens has an ROE quite close to the Luxury industry average (23%).
It’s not surprising, but it’s respectable. Although the ROE is similar to that of the industry, we still need to perform further checks to see if the company’s ROE is being boosted by high debt levels. If so, it increases its exposure to financial risk. To learn about the 4 risks we have identified for Dr. Martens, visit our risk dashboard for free.
What is the impact of debt on 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 two cases, the ROE will capture this use of capital to grow. 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.
Combine Dr. Martens debt and his 27% return on equity
Of note is Dr. Martens’ heavy use of debt, leading to his debt-to-equity ratio of 1.40. There’s no doubt that ROE is impressive, but it’s worth bearing in mind that the metric could have been lower had the company reduced its debt. Debt brings additional risk, so it’s only really worth it when a business is generating decent returns.
Return on equity is useful for comparing the quality of different companies. Companies that can earn high returns on equity without too much debt are generally of good quality. If two companies have the same ROE, I would generally prefer the one with less debt.
But ROE is only one piece of a larger puzzle, as high-quality companies often trade on high earnings multiples. 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.