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. We will use ROE to examine International Business Machines Corporation (NYSE:IBM) using a working example.
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 other words, it shows the company’s success in turning shareholders’ investments into profits.
Check out our latest analysis for International Business Machines
How do you calculate return on equity?
The Formula for return on equity Is:
Return on Equity = Net Income (from continuing operations) ÷ Equity
So, based on the above formula, the ROE for international business machines is:
8.1% = $1.8 billion ÷ $22 billion (based on trailing 12 months to December 2022).
The “return” is the annual profit. One way to conceptualize this is that for every $1 in shareholder equity, the company makes $0.08 in profit.
Do international business machines 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. However, this method only makes sense as a rough check, since companies within the same industry classification are quite different. As shown in the image below, International Business Machines has a lower ROE than the average (16%) in the IT industry.
That’s definitely not ideal. However, a low ROE is not always bad. If the company’s debt is moderate to low, there’s still a chance the return can be improved through the use of financial leverage. If a company has low ROE but high debt, we would be cautious as the risk involved is too high. To learn the 5 risks we have identified for international business machines visit our risk dashboard for free.
How does debt affect ROE?
Almost all companies need money to invest in the business and make a profit. This money can come from retained earnings, the issuance of new shares (equity), or debt. 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.
Combines International Business Machines’ debt and its 8.1% return on equity
Notable is International Business Machines’ high leverage, which resulted in a leverage ratio of 2.30. Its ROE is fairly low even using significant debt; In our opinion, this is not a good result. Investors should think carefully about how a company might fare if it couldn’t borrow easily, as credit markets change over time.
Summary
Return on equity is a useful indicator of a company’s ability to generate profits and return them to shareholders. On our books, the highest quality companies have high returns on equity despite low levels of debt. All other things being equal, higher ROE is better.
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. So you might want to check out this FREE visualization of analyst forecasts for the company.
But beware: International Business Machines might not be the best stock to buy. So check this out free List of interesting companies with high ROE and low leverage.
Do you have any feedback about this article? Concerned about the content? Get in touch directly with us. Alternatively, send an email to the editorial team (at) simplywallst.com.
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.
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