Many investors are still educating themselves about the various metrics that can be useful when analyzing a stock. This article is for those who want to learn more about return on equity (ROE). We’ll use ROE to take a look at Kellogg Company (NYSE: K), using a real-world example.
Return on equity or ROE is a key metric used to assess the efficiency with which the management of a business is using business capital. In other words, it is a profitability ratio that measures the rate of return on capital contributed by the shareholders of the company.
See our latest review for Kellogg
How is the ROE calculated?
Return on equity can be calculated using the formula:
Return on equity = Net income (from continuing operations) ÷ Equity
So, based on the above formula, Kellogg’s ROE is:
35% = US $ 1.3 billion ÷ US $ 3.7 billion (based on the last twelve months to April 2021).
The “return” is the annual profit. This therefore means that for every $ 1 invested by its shareholder, the company generates a profit of $ 0.35.
Does Kellogg 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 industry classification. Fortunately, Kellogg has a higher ROE than the food industry average (11%).
It’s a good sign. However, keep in mind that a high ROE does not necessarily indicate efficient profit generation. Besides changes in net income, high ROE can also be the result of high leverage to equity, which indicates risk. You can see the 2 risks we have identified for Kellogg by visiting our risk dashboard for free on our platform here.
Why You Should Consider Debt When Looking At ROE
Businesses generally need to invest money to increase their profits. This liquidity can come from retained earnings, the issuance of new shares (shares) or debt. In the first two cases, the ROE will capture this use of capital to grow. In the latter case, the use of debt will improve returns, but will not affect equity. In this way, the use of debt will increase the ROE, even if the basic economy of the business remains the same.
Combine Kellogg’s Debt and Its 35% Return on Equity
Noteworthy is Kellogg’s high reliance on debt, leading to its debt-to-equity ratio of 2.11. While there is no doubt that its ROE is impressive, we would have been even more impressed if the company had achieved this goal with lower debt. Investors should think carefully about how a business will perform if it weren’t able to borrow so easily, as credit markets change over time.
Return on equity is useful for comparing the quality of different companies. A business that can earn a high return on equity without going into debt could be considered a high quality business. If two companies have the same ROE, then I would generally prefer the one with the least amount of debt.
That said, while ROE is a useful indicator of how good a business is, you’ll need to look at a whole range of factors to determine the right price to buy a stock. It is important to take into account other factors, such as future profit growth and the amount of investment required for the future. So I think it’s worth checking this out free analyst forecast report for the company.
If you would rather consult with another company – one with potentially superior finances – then don’t miss this free list of interesting companies, which have a HIGH return on equity and low leverage.
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This Simply Wall St article is general in nature. It does not constitute a recommendation to buy or sell shares and does not take into account your goals or your financial situation. Our aim is to bring you long-term, targeted analysis based on fundamental data. Note that our analysis may not take into account the latest announcements from price sensitive companies or qualitative documents. Simply Wall St has no position in any of the stocks mentioned.
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