One of the best investments we can make is ardell red gold corrector plus before and afterin 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. We’ll use ROE to examine ITT Inc. (

NYSE:ITT

), by way of a worked example.

Over the last twelve months

ITT has recorded a ROE of 12%

. One way to conceptualize this, is that for each $1 of shareholders’ equity it has, the company made $0.12 in profit.

See our latest analysis for ITT

How Do You Calculate Return On Equity?

The

formula for ROE

is:

Return on Equity = Net Profit ÷ Shareholders’ Equity

Or for ITT:

12% = 215.8 ÷ US$1.8b (Based on the trailing twelve months to September 2018.)

Most know that net profit is the total earnings after all expenses, but the concept of shareholders’ equity is a little more complicated. It is all earnings retained by the company, plus any capital paid in by shareholders. You can calculate shareholders’ equity by subtracting the company’s total liabilities from its total assets.

What Does ROE Signify?

ROE looks at the amount a company earns relative to the money it has kept within the business. The ‘return’ is the yearly profit. The higher the ROE, the more profit the company is making. So, all else equal,

investors should like a high ROE

. Clearly, then, one can use ROE to compare different companies.

Does ITT Have A Good ROE?

Arguably the easiest way to assess company’s ROE is to compare it with the average in its industry. Importantly, this is far from a perfect measure, because companies differ significantly within the same industry classification. You can see in the graphic below that ITT has an ROE that is fairly close to the average for the Machinery industry (13%).

NYSE:ITT Last Perf January 2nd 19

That’s neither particularly good, nor bad. ROE doesn’t tell us if the share price is low, but it can inform us to the nature of the business. For those looking for a bargain, other factors may be more important. If you are like me, then you will

not

want to miss this

free

list of growing companies that insiders are buying.

Why You Should Consider Debt When Looking At ROE

Companies usually need to invest money 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 debt used for growth will improve returns, but won’t affect the total equity. That will make the ROE look better than if no debt was used.

Combining ITT’s Debt And Its 12% Return On Equity

While ITT does have a tiny amount of debt, with debt to equity of just 0.087, we think the use of debt is very modest. 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.

Story continues

The Bottom Line On ROE

Return on equity is one way we can compare the business quality of different companies. A company that can achieve a high return on equity without debt could be considered a high quality business. All else being equal, a higher ROE is better.

But ROE is just one piece of a bigger puzzle, since high quality businesses often trade on high multiples of earnings. It is important to consider other factors, such as future profit growth — and how much investment is required going forward. So you might want to check this FREE

visualization of analyst forecasts for the company

.

But note:

ITT may not be the best stock to buy

. So take a peek at this

free

list of interesting companies with 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

[email protected]

.

View comments