Many investors are still learning about the various metrics that can be useful when analysing a stock. This article is for those who would like to learn about Return On Equity (ROE). We'll use ROE to examine Titan Machinery Inc. (NASDAQ:TITN), by way of a worked example.

Return on equity or ROE is an important factor to be considered by a shareholder because it tells them how effectively their capital is being reinvested. In other words, it is a profitability ratio which measures the rate of return on the capital provided by the company's shareholders.

Check out our latest analysis for Titan Machinery

How Do You Calculate Return On Equity?

The formula for return on equity is:

Return on Equity = Net Profit (from continuing operations) ÷ Shareholders' Equity

So, based on the above formula, the ROE for Titan Machinery is:

17% = US$107m ÷ US$626m (Based on the trailing twelve months to October 2023).

The 'return' refers to a company's earnings over the last year. That means that for every $1 worth of shareholders' equity, the company generated $0.17 in profit.

Does Titan Machinery Have A Good Return On Equity?

One simple way to determine if a company has a good return on equity is to compare it to the average for its industry. The limitation of this approach is that some companies are quite different from others, even within the same industry classification. You can see in the graphic below that Titan Machinery has an ROE that is fairly close to the average for the Trade Distributors industry (19%).

That's neither particularly good, nor bad. Even if the ROE is respectable when compared to the industry, its worth checking if the firm's ROE is being aided by high debt levels. If true, then it is more an indication of risk than the potential. You can see the 3 risks we have identified for Titan Machinery by visiting our risks dashboard for free on our platform here.

The Importance Of Debt To Return On Equity

Virtually all companies need money to invest in the business, to grow profits. The cash for investment can come from prior year profits (retained earnings), issuing new shares, or borrowing. In the first two cases, the ROE will capture this use of capital to grow. In the latter case, the use of debt will improve the returns, but will not change the equity. Thus the use of debt can improve ROE, albeit along with extra risk in the case of stormy weather, metaphorically speaking.

Combining Titan Machinery's Debt And Its 17% Return On Equity

It's worth noting the high use of debt by Titan Machinery, leading to its debt to equity ratio of 1.27. While its ROE is respectable, it is worth keeping in mind that there is usually a limit as to how much debt a company can use. Investors should think carefully about how a company might perform if it was unable to borrow so easily, because credit markets do change over time.