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. Learning by doing, we will examine ROE to better understand Masonite International Corporation (NYSE: DOOR).
ROE or return on equity is a useful tool for evaluating how effectively a company can generate returns on the investment it has received from its shareholders. In other words, it reveals the company’s success in turning shareholders’ investments into profits.
How is ROE calculated?
ROE 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:
19% = $120 million ÷ $626 million (based on trailing 12 months to April 2022).
The “yield” is the amount earned after tax over the last twelve months. This therefore means that for every $1 of investment by its shareholder, the company generates a profit of $0.19.
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. It is important to note that this measure is far from perfect, as companies differ significantly within the same industry classification. You can see in the graph below that Masonite International has an ROE that is quite close to the average for the Building industry (19%).
It’s not surprising, but it’s respectable. 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. To learn about the 2 risks we have identified for Masonite International visit our risk dashboard for free.
What is the impact of debt on ROE?
Companies generally need to invest money 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 use of debt will improve returns, but will not change equity. This will make the ROE better than if no debt was used.
Combine Masonite International’s debt and 19% return on equity
Masonite International is clearly using a high amount of debt to boost returns, as it has a leverage ratio of 1.38. There’s no doubt that its ROE is decent, but the company’s sky-high debt isn’t too exciting to see. 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 useful for comparing the quality of different companies. Companies that can earn high returns on equity without too much debt are generally of good quality. If two companies have roughly the same level of debt and one has a higher ROE, I generally prefer the one with a higher ROE.
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. It is important to consider other factors, such as future earnings growth and the amount of investment needed in the future. So you might want to take a look at this data-rich interactive chart of business forecasts.
Sure Masonite International may not be the best stock to buy. So you might want to see this free collection of other companies that have high ROE 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.
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