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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. By way of learning-by-doing, we'll look at ROE to gain a better understanding of Fastenal Company (NASDAQ:FAST).Fastenal has a ROE of 32%, based on the last twelve months. Another way to think of that is that for every $1 worth of equity in the company, it was able to earn $0.32.The formula for return on equity is:Return on Equity = Net Profit ÷ Shareholders' EquityOr for Fastenal:32% = US$772m ÷ US$2.4b (Based on the trailing twelve months to March 2019.)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 measures a company's profitability against the profit it retains, and any outside investments. The 'return' is the amount earned after tax over the last twelve months. That means that the higher the ROE, the more profitable the company is. So, all else being equal, a high ROE is better than a low one. That means it can be interesting to compare the ROE of different companies.Daily chart:http://schrts.co/ZbVDGbqZ
Hi Thom,A useful way of thinking about ROE is in terms of a Dupont Analysis:https://en.wikipedia.org/wiki/DuPont_analysisROE = Net Margin * Asset Turnover * Financial LeverageFAST is attractive, compared to other firms, because it earns a relative high net margin, high asset turnover and uses modest financial leverage.Comparing two different companies using these 3 components to ROE allows an investor to "see" just how they earn their profits. If 2 companies earn identical ROE, the one with the lower financial leverage would be more desirable (less debt = less risk).Rich
Take care with the trailing 12 months of earnings. They are elevated (net margins now around 15%) beyond what it has generally sustained for the same level of sales (net margins around 12%) so I expect there will be some one-off effects in the earnings.Rather than using 12 months for the margin, one can use a few years as a quick and dirty way to normalise (or if calculating using earnings, then use the average of the last 3 years of earnings). It is better of course to normalise the earnings by understanding why there is a one-off spike or depression in the earnings as it appears with Fastenal. It it might be okay and they can sustain the present margins, but if so then you should have reason to believe why that is so also.I'm looking at this one from an extreme distance - I haven't even read their reports and don't know much at all about this firm.- Manlobbi
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