In This Article:
One of the best investments we can make is in our own knowledge and skill set. With that in mind, this article will work through how we can use Return On Equity (ROE) to better understand a business. By way of learning-by-doing, we'll look at ROE to gain a better understanding of Harvey Norman Holdings Limited (ASX:HVN).
Over the last twelve months Harvey Norman Holdings has recorded a ROE of 13%. One way to conceptualize this, is that for each A$1 of shareholders' equity it has, the company made A$0.13 in profit.
Check out our latest analysis for Harvey Norman Holdings
How Do I Calculate ROE?
The formula for ROE is:
Return on Equity = Net Profit ÷ Shareholders' Equity
Or for Harvey Norman Holdings:
13% = AU$390m ÷ AU$3.2b (Based on the trailing twelve months to December 2018.)
It's easy to understand the 'net profit' part of that equation, but 'shareholders' equity' requires further explanation. It is all earnings retained by the company, plus any capital paid in by shareholders. The easiest way to calculate shareholders' equity is to subtract the company's total liabilities from the total assets.
What Does ROE Mean?
ROE looks at the amount a company earns relative to the money it has kept within the business. The 'return' is the profit over the last twelve months. The higher the ROE, the more profit the company is making. So, all else equal, investors should like a high ROE. That means ROE can be used to compare two businesses.
Does Harvey Norman Holdings Have A Good ROE?
Arguably the easiest way to assess company's ROE is to compare it with the average in its industry. 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, Harvey Norman Holdings has a better ROE than the average (6.1%) in the Multiline Retail industry.
That's what I like to see. In my book, a high ROE almost always warrants a closer look. One data point to check is if insiders have bought shares recently.
The Importance Of Debt To Return On Equity
Most companies need money -- from somewhere -- to grow their profits. That cash can come from retained earnings, issuing new shares (equity), 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. That will make the ROE look better than if no debt was used.
Combining Harvey Norman Holdings's Debt And Its 13% Return On Equity
While Harvey Norman Holdings does have some debt, with debt to equity of just 0.26, we wouldn't say debt is excessive. The fact that it achieved a fairly good ROE with only modest debt suggests the business might be worth putting on your watchlist. Judicious use of debt to improve returns can certainly be a good thing, although it does elevate risk slightly and reduce future optionality.