Is NEXT plc (LON:NXT) ROE better than average at 67%?

One of the best investments we can make is in our own knowledge and skills. With that in mind, this article will work through how we can use return on equity (ROE) to better understand a company. To keep the lesson practical, let’s use ROE to better understand NEXT plc (LON:NXT).

Return on Equity, or ROE, is a key metric used to assess how efficiently a company’s management is using the company’s capital. In other words, it shows the company’s success in turning shareholders’ investments into profits.

Check out our latest analysis for NEXT

How do you calculate return on equity?

The ROE can be calculated using the following formula:

Return on Equity = Net Income (from continuing operations) ÷ Equity

So, based on the formula above, the ROE for NEXT is:

67% = £678m ÷ £1.0bn (based on trailing 12 months to January 2022).

The “return” is the income that the company has made in the last year. This means that for every £1 of equity the company makes £0.67 in profit.

Does NEXT have a good ROE?

Arguably the easiest way to evaluate a company’s ROE is to compare it to its industry average. Importantly, this is far from a perfect measure, as companies vary significantly within the same industry classification. As shown in the image below, NEXT has a better ROE than average (33%) in the multiline retail industry.

We like to see that. However, high ROE does not always indicate high profitability. Net income changes aside, high ROE can also be the result of high debt-to-equity ratio, indicating risk. You can see the 2 risks we have identified for NEXT by visiting our Risk Dashboard for free on our platform here.

Why you should think about debt when looking at ROE

Businesses usually need to invest money to increase their profits. This money can come from retained earnings, the issuance of new shares (equity), or debt. In the first two cases, ROE captures this capital investment for growth. In the latter case, the use of debt will improve returns but will not change equity. Therefore, the use of leverage can improve ROE, albeit figuratively with additional risk in stormy weather.

Combines NEXT’s debt and its 67% return on equity

Worth mentioning is NEXT’s high leverage, which resulted in a gearing ratio of 1.04. Its ROE is pretty impressive, but it probably would have been lower without the use of debt. Debt comes with an additional risk, so it’s only worth it if a company can get a decent return on it.

summary

Return on equity is useful for comparing the quality of different companies. A company that can generate a high return on equity with no debt could be considered a high quality company. Generally, if two companies have the same ROE, I’d prefer the one with less debt.

But when a company is of high quality, the market often offers it at a price that reflects that. Earnings growth rates versus expectations reflected in the stock price are particularly important to consider. You might want to take a look at this data-rich interactive chart of forecasts for the company.

But beware: NEXT might not be the best stock to buy. So check this out free List of interesting companies with high ROE and low leverage.

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This Simply Wall St article is of a general nature. We provide comments based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended as financial advice. It is not a recommendation to buy or sell any stock and does not take into account your goals or financial situation. Our goal is to offer you long-term focused analysis based on fundamental data. Note that our analysis may not take into account the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any of the stocks mentioned.