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. We will use ROE to examine Cable One, Inc. (NYSE: CABO), 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 other words, it reveals the company’s success in turning shareholders’ investments into profits.
How do you 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 Cable One is:
18% = $235 million ÷ $1.3 billion (based on trailing 12 months to June 2020).
The “yield” is the amount earned after tax over the last twelve months. Another way to think about this is that for every dollar of equity, the company was able to make a profit of $0.18.
Does Cable One have a good ROE?
Perhaps the easiest way to assess a company’s ROE is to compare it to the industry average. The limitation of this approach is that some companies are very different from others, even within the same industrial classification. Fortunately, Cable One has an ROE above the media industry average (13%).
That’s what we like to see. That said, a high ROE does not always mean high profitability. A higher proportion of debt in a company’s capital structure can also result in a high ROE, where high debt levels could be a huge risk. To find out about the 3 risks we have identified for Cable One, visit our risk dashboard for free.
What is the impact of debt on ROE?
Companies generally need to invest money to increase their profits. This money can come from retained earnings, issuing new stock (shares), or debt. 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.
Cable One’s debt and its 18% ROE
Of note is Cable One’s high reliance on debt, which has led to its debt-to-equity ratio of 1.47. 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 a way to compare the business quality of different companies. In our books, the highest quality companies have a high return on equity, despite low leverage. 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. The rate at which earnings are likely to grow, relative to earnings growth expectations reflected in the current price, should also be considered. So I think it’s worth checking it out free analyst forecast report for the company.
Sure Cable One 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.
This Simply Wall St article is general in nature. 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.