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. We’ll use the ROE to take a look at Inari Medical, Inc. (NASDAQ: NARI), using a real-world example.
Return on equity or ROE is a test of how effectively a company increases its value and manages investor money. Simply put, it is used to assess a company’s profitability against its equity.
See our latest review for Inari Medical
How do you calculate return on equity?
ROE can be calculated using the formula:
Return on equity = Net income (from continuing operations) ÷ Equity
Thus, based on the above formula, the ROE for Inari Medical is:
6.7% = US $ 16 million ÷ US $ 234 million (based on the last twelve months to September 2021).
The “return” is the amount earned after tax over the past twelve months. This means that for every dollar in shareholders’ equity, the company generated $ 0.07 in profit.
Does Inari Medical have a good ROE?
By comparing a company’s ROE with its industry average, we can get a quick measure of its quality. However, this method is only useful as a rough check, as companies differ a lot within a single industry classification. If you look at the image below, you can see that Inari Medical has a lower ROE than the average (11%) for the medical device industry classification.
It is certainly not ideal. However, a low ROE is not always bad. If the company’s debt levels are moderate to low, there is still a chance that returns can be improved through the use of financial leverage. A highly leveraged business with a low ROE is a whole different story and a risky investment on our books. Our risk dashboard should contain the 3 risks that we have identified for Inari Medical.
The importance of debt to return on equity
Most businesses need money – from somewhere – to increase their profits. This liquidity can come from the issuance of 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 increase returns, but will have no impact on equity. In this way, the use of debt will increase the ROE, even if the basic economy of the business remains the same.
Combine Inari Medical’s debt and its 6.7% return on equity
Inari Medical is net debt free, which is good for shareholders. Even though I don’t think his ROE is that high, I think he is very respectable considering that he has no debt. Ultimately, when a business is debt free, it is in a better position to seize future growth opportunities.
Return on equity is a useful indicator of a company’s ability to generate profits and return them to shareholders. Firms that can earn high returns on equity without taking on too much debt are generally of good quality. If two companies have the same ROE, 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. Especially important to consider are the growth rates of earnings, relative to expectations reflected in the stock price. 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.
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 any stock 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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