One of the best investments we can make is in our own knowledge and skills. With that in mind, this article will discuss how we can use Return on Equity (ROE) to better understand a business. To keep the lesson grounded in practice, we’ll use ROE to better understand Doximity, Inc. (NYSE: DOCS).
ROE or return on equity is a useful tool to assess how effectively a company can generate the returns on investment it has received from its shareholders. In simpler terms, it measures a company’s profitability relative to equity.
Check out our latest review for Doximity
How to calculate return on equity?
The formula for ROE is:
Return on equity = Net income (from continuing operations) ÷ Equity
So, based on the above formula, Doximity’s ROE is:
10% = US $ 75 million ÷ US $ 728 million (based on the last twelve months to June 2021).
The “return” is the profit of the last twelve months. Another way of thinking is that for every dollar of equity, the company was able to make $ 0.10 in profit.
Does Doximity have a good ROE?
A simple way to determine if a company has a good return on equity is to compare it to the average in its industry. It is important to note that this measure is far from perfect, as companies differ considerably within a single industry classification. Fortunately, Doximity has an above-average ROE (7.1%) for the healthcare industry.
This is what we love to see. That said, high ROE doesn’t always indicate high profitability. A higher proportion of debt in a company’s capital structure can also result in high ROE, where high debt levels could represent a huge risk. You can see the 2 risks we have identified for Doximity by visiting our risk dashboard for free on our platform here.
The importance of debt to return on equity
Businesses generally need to invest money to increase their profits. The money for the investment can come from the profits of the previous year (retained earnings), from the issuance of new shares or from loans. 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 used for growth will improve returns, but will not affect total equity. So, using debt can improve ROE, but with added risk in stormy weather, metaphorically speaking.
Combine Doximity’s debt and its 10% return on equity
A positive point for shareholders, Doximity has no net debt! Its respectable ROE suggests that this is a business to watch, but it’s even better if the business got there without leverage. After all, when a business has a strong balance sheet, it can often find ways to invest in growth, even if it takes a while.
Conclusion
Return on equity is useful for comparing the quality of different companies. In our books, the highest quality companies have a high return on equity, despite low leverage. If two companies have the same ROE, then I would generally prefer the one with the least amount of debt.
But when a company is of high quality, the market often offers it up to a price that reflects that. The rate at which earnings are likely to grow, relative to earnings growth expectations reflected in the current price, should also be considered. You might want to take a look at this data-rich interactive chart of the forecast for the business.
Sure Doximity might not be the best stock to buy. So you might want to see this free collection of other companies with high ROE and low leverage.
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This Simply Wall St article is general in nature. We provide commentary based on historical data and analyst forecasts using only unbiased methodology and our articles are not intended to be financial advice. 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 the mentioned stocks.
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