While some investors are already well versed in financial metrics (hat tip), this article is for those who would like to learn about Return On Equity (ROE) and why it is important. To keep the lesson grounded in practicality, we'll use ROE to better understand Installed Building Products, Inc. (NYSE:IBP).
ROE or return on equity is a useful tool to assess how effectively a company can generate returns on the investment it received from its shareholders. In short, ROE shows the profit each dollar generates with respect to its shareholder investments.
Our free stock report includes 1 warning sign investors should be aware of before investing in Installed Building Products. Read for free now.How Is ROE Calculated?
Return on equity can be calculated by using the formula:
Return on Equity = Net Profit (from continuing operations) ÷ Shareholders' Equity
So, based on the above formula, the ROE for Installed Building Products is:
36% = US$257m ÷ US$705m (Based on the trailing twelve months to December 2024).
The 'return' refers to a company's earnings over the last year. One way to conceptualize this is that for each $1 of shareholders' capital it has, the company made $0.36 in profit.
See our latest analysis for Installed Building Products
Does Installed Building Products Have A Good ROE?
One simple way to determine if a company has a good return on equity is to compare it to the average for its industry. The limitation of this approach is that some companies are quite different from others, even within the same industry classification. As is clear from the image below, Installed Building Products has a better ROE than the average (16%) in the Consumer Durables industry.
That's clearly a positive. However, bear in mind that a high ROE doesn’t necessarily indicate efficient profit generation. A higher proportion of debt in a company's capital structure may also result in a high ROE, where the high debt levels could be a huge risk .
How Does Debt Impact ROE?
Companies usually need to invest money to grow their profits. That cash can come from retained earnings, issuing new shares (equity), or debt. In the case of the first and second options, the ROE will reflect this use of cash, for growth. In the latter case, the debt required for growth will boost returns, but will not impact the shareholders' equity. That will make the ROE look better than if no debt was used.
Installed Building Products' Debt And Its 36% ROE
Installed Building Products does use a high amount of debt to increase returns. It has a debt to equity ratio of 1.24. There's no doubt the ROE is impressive, but it's worth keeping in mind that the metric could have been lower if the company were to reduce its debt. Debt increases risk and reduces options for the company in the future, so you generally want to see some good returns from using it.
Conclusion
Return on equity is one way we can compare its business quality of different companies. Companies that can achieve high returns on equity without too much debt are generally of good quality. All else being equal, a higher ROE is better.
Having said that, while ROE is a useful indicator of business quality, you'll have to look at a whole range of factors to determine the right price to buy a stock. The rate at which profits are likely to grow, relative to the expectations of profit growth reflected in the current price, must be considered, too. So you might want to check this FREE visualization of analyst forecasts for the company.
Of course Installed Building Products may not be the best stock to buy. So you may wish to see this free collection of other companies that have high ROE and low debt.
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This article by Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any stocks mentioned.