One of the best investments we can make is in our own knowledge and skills. With that in mind, this article will explain how we can use return on equity (ROE) to better understand a business. We’ll use ROE to look at The Vita Coco Company, Inc. (NASDAQ:COCO), as a real-world example.
Return on equity or ROE is a key metric used to gauge how effectively a company’s management is using the company’s capital. In simpler terms, it measures a company’s profitability relative to equity.
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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 Vita Coco Company is:
9.9% = $13 million ÷ $131 million (based on trailing 12 months to June 2022).
“Yield” is the income the business has earned over the past year. One way to conceptualize this is that for every $1 of share capital it has, the firm has made a profit of $0.10.
Does Vita Coco Company have a good return on equity?
A simple way to determine if a company has a good return on equity is to compare it to the average for its industry. However, this method is only useful as a rough check, as companies differ quite a bit within the same industry classification. As shown in the graph below, Vita Coco Company has an ROE below the average (15%) of the beverage industry classification.
Unfortunately, this is suboptimal. That being said, a low ROE is not always a bad thing, especially if the company has low leverage, as it still leaves room for improvement should the company take on more debt. A company with high debt levels and low ROE is a combination we like to avoid given the risk involved. Our risk dashboard should have the 3 risks we identified for Vita Coco Company.
What is the impact of debt on ROE?
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 first and second case, the ROE will reflect this use of cash for investment in the business. In the latter case, the use of debt will improve returns, but will not change equity. So using debt can improve ROE, but with the added risk of stormy weather, metaphorically speaking.
Vita Coco Company’s debt and its ROE of 9.9%
Vita Coco Company has a debt ratio of 0.17, which is far from excessive. I’m not impressed with its ROE, but the debt levels aren’t too high, indicating the company has a decent outlook. Judicious use of debt to improve returns can certainly be a good thing, even if it slightly increases risk and reduces future optionality.
Return on equity is a useful indicator of a company’s ability to generate profits and return them to shareholders. In our books, the highest quality companies have a high return on equity, despite low leverage. All things being equal, a higher ROE is better.
But ROE is only one piece of a larger puzzle, as high-quality companies often trade on high earnings multiples. It is important to consider other factors, such as future earnings growth and the amount of investment needed in the future. You might want to check out this FREE analyst forecast visualization for the company.
Sure, you might find a fantastic investment by looking elsewhere. So take a look at this free list of interesting companies.
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This Simply Wall St article is general in nature. We provide commentary based on historical data and analyst forecasts only using unbiased methodology and our articles are not intended to be financial advice. It is not a recommendation to buy or sell stocks and does not take into account your objectives or financial situation. Our goal is to bring you targeted long-term analysis based on fundamental data. Note that our analysis may not take into account the latest announcements from price-sensitive companies or qualitative materials. Simply Wall St has no position in the stocks mentioned.
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