While some investors are already familiar with financial metrics (hat trick), this article is for those who want to learn more about return on equity (ROE) and why it matters. We will use ROE to review Bowman Consulting Group Ltd. (NASDAQ:BWMN), as a concrete example.
Return on Equity or ROE is a test of how effectively a company increases its value and manages investors’ money. In simple terms, it is used to assess the profitability of a company in relation to its equity.
Check out our latest analysis for Bowman Consulting Group
How to calculate return on equity?
The return on equity formula is:
Return on equity = Net income (from continuing operations) ÷ Equity
So, based on the above formula, the ROE for Bowman Consulting Group is:
0.8% = $775,000 ÷ $98 million (based on trailing 12 months to March 2022).
“Yield” refers to a company’s earnings over the past year. Another way to think about this is that for every dollar of equity, the company was able to make a profit of $0.01.
Does Bowman Consulting Group have a good return on equity?
By comparing a company’s ROE with the average for its industry, we can get a quick measure of its quality. It is important to note that this measure is far from perfect, as companies differ significantly within the same industry classification. As shown in the graph below, Bowman Consulting Group has an ROE below the construction industry classification average (9.4%).
That’s not what we like to see. However, we believe that a lower ROE could still mean that a company has the opportunity to improve its returns through the use of leverage, provided its existing debt levels are low. A highly leveraged company with a low ROE is a whole other story and a risky investment on our books. You can see the 4 risks we have identified for Bowman Consulting Group by visiting our risk dashboard for free on our platform here.
What is the impact of debt on ROE?
Companies generally need to invest money to increase their profits. This money can come from issuing shares, retained earnings or debt. In the first two cases, the ROE will capture this use of capital to grow. In the latter case, the debt necessary for growth will boost returns, but will not impact shareholders’ equity. This will make the ROE better than if no debt was used.
Bowman Consulting Group’s debt and its ROE of 0.8%
Bowman Consulting Group has a debt ratio of 0.12, which is far from excessive. His ROE is certainly low, and since he’s already using debt, we’re not too excited about the company. Judicious use of debt to improve returns can certainly be a good thing, even if it slightly increases risk and reduces future optionality.
Return on equity is useful for comparing the quality of different companies. A company that can earn a high return on equity without going into debt could be considered a high quality company. 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.
But when a company is of high quality, the market often gives it a price that reflects that. Earnings growth rates, relative to expectations reflected in the share price, are particularly important to consider. So I think it’s worth checking it out free analyst forecast report for the company.
Sure, you might find a fantastic investment by looking elsewhere. So take a look at this free list of interesting companies.
Feedback on this article? Concerned about content? Get in touch with us directly. You can also email the editorial team (at) Simplywallst.com.
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.
Join a Paid User Research Session
You will receive a $30 Amazon Gift Card for 1 hour of your time while helping us create better investment tools for individual investors like you. register here