One of the best investments we can make is our own knowledge and skill sets. With that in mind, this article discusses how to use Return on Equity (ROE) to better understand your business. As a real-life example, use ROE to look at Nordstrom (NYSE:JWN).
ROE, or Return on Equity, is a useful tool for evaluating how effectively a company is able to generate returns on the investment it receives from its shareholders. Simply put, it is used to assess a company’s profitability relative to its equity capital.
Check out Nordstrom’s latest analysis.
How do you calculate return on equity?
Return on equity can be calculated using the following formula:
Return on Equity = Net Income (from Continuing Operations) ÷ Shareholders’ Equity
So, based on the formula above, Nordstrom’s ROE would be:
3.6% = US$20 million ÷ US$551 million (based on last 12 months to April 2023).
“Revenue” is the amount of earnings after tax for the last 12 months. That is, for every $1 a shareholder invests, the company will generate his $0.04 profit.
Is Nordstrom’s ROE strong?
Comparing a company’s ROE to the industry average is an easy way to measure how good a company is. A limitation of this approach is that some companies are very different from others, even within the same industry classification. As shown in the chart below, Nordstrom’s ROE is lower than the multiline retail industry classification average (11%).
Unfortunately it’s not optimal. However, as long as existing debt levels are low, we believe that even a low ROE means there is an opportunity for a company to use leverage to improve earnings. Companies with high debt levels and low ROEs are a combination he wants to avoid due to risk considerations. You can read more about the four risks I identified for Nordstrom by visiting his website at our company. risk dashboard Available for free on this platform.
How does debt affect ROE?
Businesses usually need to invest money to increase their profits. That cash can come from retained earnings, the issuance of new shares (shares), or debt. For the first and second options, ROE reflects the use of cash for growth. In the latter case, the debt required for growth drives earnings, but does not affect shareholders’ equity. Then the ROE would be better than if they didn’t borrow.
Combined with Nordstrom’s debt and 3.6% return on equity,
Nordstrom appears to be using huge amounts of debt to fund its operations, given its extremely high debt-to-equity ratio of 5.19. Most investors need low stock prices to be interested in companies with low ROE and high debt-to-equity ratios.
Conclusion
Return on equity helps you compare the quality of different businesses. A company that can achieve a high return on equity without debt is a high-quality company. If two companies have about the same level of capital to debt and one company has a higher ROE, I usually prefer the company with the higher ROE.
That said, while ROE is a useful indicator of the quality of your business, determining the right price to buy a stock requires consideration of many factors. It is important to consider other factors such as future profit growth and how much future investment is required. So it’s good to take a peek at the data-rich interactive charts that show the company’s forecasts.
of course, Look elsewhere and you may find a great investment. so take a look at this free A list of interesting companies.
Valuation is complicated, but we’re here to help make it simple.
Check out our comprehensive analysis, including the following, to see if Nordstrom is potentially over- or undervalued. Fair value estimates, risks and warnings, dividends, insider trading and financial health.
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This article by Simply Wall St is general in nature. We provide commentary based on historical data and analyst projections using only unbiased methodologies and articles are not intended as financial advice. This is not a recommendation to buy or sell stocks and does not take into account your objectives or financial situation. We aim to provide long-term, focused analysis based on underlying data. Please note that our analysis may not take into account the latest announcements or qualitative material from price-sensitive companies. Simply Wall St does not have any positions in any of the securities mentioned.
