While some investors are already well versed in financial metrics (hat tip), this article is for those who would like to learn about Return On Equity (ROE) and why it is important. We’ll use ROE to examine General Mills, Inc. (NYSE:GIS), by way of a worked example.

Our data shows General Mills has a return on equity of 27% for the last year. One way to conceptualize this, is that for each $1 of shareholders’ equity it has, the company made $0.27 in profit.

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How Do You Calculate Return On Equity?

The formula for return on equity is:

Return on Equity = Net Profit ÷ Shareholders’ Equity

Or for General Mills:

27% = 2031.5 ÷ US$7.5b (Based on the trailing twelve months to November 2018.)

It’s easy to understand the ‘net profit’ part of that equation, but ‘shareholders’ equity’ requires further explanation. It is the capital paid in by shareholders, plus any retained earnings. The easiest way to calculate shareholders’ equity is to subtract the company’s total liabilities from the total assets.

What Does Return On Equity Mean?

ROE looks at the amount a company earns relative to the money it has kept within the business. The ‘return’ is the profit over the last twelve months. That means that the higher the ROE, the more profitable the company is. So, as a general rule, a high ROE is a good thing. That means it can be interesting to compare the ROE of different companies.

Does General Mills Have A Good ROE?

Arguably the easiest way to assess company’s ROE is to compare it with the average in its industry. Importantly, this is far from a perfect measure, because companies differ significantly within the same industry classification. Pleasingly, General Mills has a superior ROE than the average (13%) company in the Food industry.

That is a good sign. We think a high ROE, alone, is usually enough to justify further research into a company. One data point to check is if insiders have bought shares recently.

Why You Should Consider Debt When Looking At ROE

Virtually all companies need money to invest in the business, to grow profits. That cash can come from retained earnings, issuing new shares (equity), 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 debt used for growth will improve returns, but won’t affect the total equity. In this manner the use of debt will boost ROE, even though the core economics of the business stay the same.

Combining General Mills’s Debt And Its 27% Return On Equity

It’s worth noting the significant use of debt by General Mills, leading to its debt to equity ratio of 2.03. While the ROE is impressive, that metric has clearly benefited from the company’s use of debt. Debt increases risk and reduces options for the company in the future, so you generally want to see some good returns from using it.

In Summary

Return on equity is useful for comparing the quality of different businesses. A company that can achieve a high return on equity without debt could be considered a high quality business. If two companies have around the same level of debt to equity, and one has a higher ROE, I’d generally prefer the one with higher ROE.

But ROE is just one piece of a bigger puzzle, since high quality businesses often trade on high multiples of earnings. It is important to consider other factors, such as future profit growth — and how much investment is required going forward. So you might want to take a peek at this data-rich interactive graph of forecasts for the company.

Of course General Mills may not be the best stock to buy. So you may wish to see this free collection of other companies that have high ROE and low debt.

To help readers see past the short term volatility of the financial market, we aim to bring you a long-term focused research analysis purely driven by fundamental data. Note that our analysis does not factor in the latest price-sensitive company announcements.

The author is an independent contributor and at the time of publication had no position in the stocks mentioned. For errors that warrant correction please contact the editor at editorial-team@simplywallst.com.