One of the best investments we can make is in our own knowledge and skills. With that in mind, this article will explain how we can use return on equity (ROE) to better understand a business. To keep the lesson grounded in practicality, we’ll use ROE to better understand Masonite International Corporation (NYSE: DOOR).
Return on equity or ROE is a key metric used to gauge how effectively a company’s management is using the company’s capital. In other words, it is a profitability ratio that measures the rate of return on capital contributed by the company’s shareholders.
See our latest analysis for Masonite International
How to calculate return on equity?
Return on equity can be calculated using the formula:
Return on equity = Net income (from continuing operations) ÷ Equity
So, based on the above formula, the ROE for Masonite International is:
20% = $152 million ÷ $740 million (based on trailing 12 months to October 2021).
“Yield” is the income the business has earned over the past year. This means that for every dollar of shareholders’ equity, the company generated $0.20 in profit.
Does Masonite International have a good ROE?
Perhaps the easiest way to assess a company’s ROE is to compare it to the industry average. However, this method is only useful as a rough check, as companies differ quite a bit within the same industry classification. If you look at the image below, you can see that Masonite International has an ROE similar to the building industry classification average (20%).
So, although the ROE is not exceptional, it is at least acceptable. Although the ROE is similar to that of the industry, we still need to perform further checks to see if the company’s ROE is being boosted by high debt levels. If true, this is more an indication of risk than potential. Our risk dashboard should contain the 3 risks we have identified for Masonite International.
Why You Should Consider Debt When Looking at ROE
Most businesses need money – from somewhere – to increase their profits. The money for the investment can come from the previous year’s earnings (retained earnings), from issuing new shares or from borrowing. In the first and second case, the ROE will reflect this use of cash for investment in the business. In the latter case, the debt necessary for growth will boost returns, but will not impact equity. In this way, the use of debt will increase ROE, even though the core economics of the business remains the same.
Masonite International’s debt and its 20% ROE
Masonite International is clearly using a high amount of debt to boost returns, as it has a leverage ratio of 1.17. While its ROE is respectable, it’s worth bearing in mind that there’s usually a limit to the amount of debt a company can use. Debt increases risk and reduces options for the business in the future, so you generally want to see good returns using it.
Return on equity is a useful indicator of a company’s ability to generate profits and return them to shareholders. In our books, the highest quality companies have a high return on equity, despite low leverage. All things being equal, a higher ROE is better.
That said, while ROE is a useful indicator of a company’s quality, you’ll need to consider a whole host of factors to determine the right price to buy a stock. The rate at which earnings are likely to grow, relative to earnings growth expectations reflected in the current price, should also be considered. You might want to take a look at this data-rich interactive chart of the company’s forecast.
If you’d rather check out another company – one with potentially superior finances – then don’t miss this free list of attractive companies, which have a high return on equity and low debt.
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This Simply Wall St article is general in nature. We provide commentary based on historical data and analyst forecasts only using unbiased methodology and our articles are not intended to be financial advice. It is not a recommendation to buy or sell stocks and does not take into account your objectives or financial situation. Our goal is to bring you targeted long-term analysis based on fundamental data. Note that our analysis may not take into account the latest announcements from price-sensitive companies or qualitative materials. Simply Wall St has no position in the stocks mentioned.