Many investors are still learning about the various metrics that can be useful when analyzing a stock. This article is intended for those who want to learn more about return on equity (ROE). To keep the lesson hands-on, we’ll use ROE to better understand WH Smith PLC (LON:SMWH).
ROE, or return on equity, is a useful tool for assessing how effectively a company is generating returns on the investment received from its shareholders. In short, ROE shows the profit each dollar generates in relation to its shareholders’ investments.
Our analysis indicates this SMWH is potentially overrated!
How do you calculate return on equity?
That Formula for return on equity is:
Return on Equity = Net Income (from continuing operations) ÷ Equity
So, based on the formula above, the ROE for WH Smith is:
17% = UK£53m ÷ UK£311m (Based on trailing 12 months to August 2022).
“Return” is the amount earned after tax over the past 12 months. This means that for every £1 of equity the company makes £0.17 in profit.
Does WH Smith have a good ROE?
A simple way to tell if a company has a good return on equity is to compare it to the industry average. Importantly, this is far from a perfect measure, as companies vary significantly within the same industry classification. If you look at the image below, you can see that WH Smith has a similar ROE to the average in the specialty retail industry classification (17%).
While the ROE is not exceptional, it is at least acceptable. Although the ROE is similar to that of the industry, we should still conduct further checks to see if the company’s ROE is being increased by high levels of debt. If true, it is an indication of risk rather than potential.
The importance of debt for return on equity
Almost all companies need money to invest in the business and make a profit. The money for investments can come from the previous year’s earnings (retained earnings), issuing new shares or taking out loans. In the first and second cases, the ROE reflects this use of cash to invest in the company. In the latter case, the debt used for growth improves returns but does not affect overall capital. In this way, the use of leverage will increase ROE even though the company’s core economics remain the same.
WH Smith’s debt and its 17% ROE
WH Smith is clearly using high leverage to enhance returns as it has a debt to equity ratio of 1.36. While ROE is respectable, it’s worth remembering that there’s usually a limit to how much debt a company can use. Investors should think carefully about how a company might fare if it couldn’t borrow easily, as credit markets change over time.
Return on equity is a useful indicator of a company’s ability to generate profits and return them to shareholders. Companies that can generate high returns on equity without over-leveraging are generally of good quality. In general, if two companies have roughly the same leverage and one has a higher ROE, I would prefer the one with the higher ROE.
But ROE is just one piece of a larger puzzle, as high-quality companies often trade at high profit multiples. It is important to consider other factors such as B. future earnings growth – and how much investment is required in the future. You might want to take a look at this data-rich interactive chart of forecasts for the company.
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The assessment is complex, but we help to simplify it.
find out if WH Smith may be over or under priced by reviewing our comprehensive analysis which includes the following Fair Value Estimates, Risks and Warnings, Dividends, Insider Trading and Financial Health.
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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.