Many investors are still learning the different metrics that can be useful when analyzing a stock. This article is for those who want to know more about return on equity (ROE). Through learning-by-doing, we will examine ROE to better understand Gladstone Commercial Corporation (NASDAQ: BON).
Return on equity or ROE is an important factor for a shareholder to consider as it tells them how much of their capital is being reinvested. In other words, it reveals the company’s success in turning shareholders’ investments into profits.
How do you calculate return on equity?
The ROE formula is:
Return on equity = Net income (from continuing operations) ÷ Equity
So, based on the above formula, the ROE for Gladstone Commercial is:
3.3% = US$13 million ÷ US$384 million (based on trailing twelve months to June 2022).
The “return” is the annual profit. Another way to think about this is that for every dollar of equity, the company was able to make a profit of $0.03.
Does Gladstone Commercial have a good return on equity?
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. As clearly shown in the image below, Gladstone Commercial has a below average ROE (6.6%) in the REIT industry.
It’s certainly not ideal. That being said, a low ROE is not always a bad thing, especially if the company has low debt, as it still leaves room for improvement if the company were to take on more debt. A highly leveraged company with a low ROE is a whole other story and a risky investment on our books. You can see the 4 risks we have identified for Gladstone Commercial by visiting our risk dashboard free on our platform here.
The Importance of Debt to Return on Equity
Virtually all businesses need money to invest in the business, to increase their profits. This money can come from issuing shares, retained earnings or debt. In the case of the first and second options, the ROE will reflect this use of cash, for growth. In the latter case, the use of debt will improve returns, but will not change equity. In this way, the use of debt will increase ROE, even though the core economics of the business remains the same.
Gladstone Commercial’s debt and its ROE of 3.3%
Gladstone Commercial uses a high amount of debt to increase returns. Its debt to equity ratio is 1.91. With a fairly low ROE and a significant reliance on debt, it is difficult to get enthusiastic about this activity at the moment. 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 useful indicator of a company’s ability to generate profits and return them to shareholders. Companies that can earn high returns on equity without too much debt are generally of good quality. If two companies have the same ROE, I would generally prefer the one with less debt.
But when a company is of high quality, the market often gives it 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. So you might want to take a look at this data-rich interactive chart of business forecasts.
But note: Gladstone Commercial may not be the best stock to buy. So take a look at this free list of interesting companies with high ROE and low debt.
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