Is Encompass Health Corporation’s (NYSE:EHC) 20% Better Than Average?

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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 Encompass Health Corporation (NYSE:EHC).

Encompass Health has a ROE of 20%, based on the last twelve months. That means that for every $1 worth of shareholders’ equity, it generated $0.20 in profit.

See our latest analysis for Encompass Health

How Do I Calculate Return On Equity?

The formula for return on equity is:

Return on Equity = Net Profit ÷ Shareholders’ Equity

Or for Encompass Health:

20% = 291.2 ÷ US$1.9b (Based on the trailing twelve months to December 2018.)

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

What Does ROE Signify?

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. The higher the ROE, the more profit the company is making. So, all else equal, investors should like a high ROE. That means it can be interesting to compare the ROE of different companies.

Does Encompass Health Have A Good Return On Equity?

By comparing a company’s ROE with its industry average, we can get a quick measure of how good it is. The limitation of this approach is that some companies are quite different from others, even within the same industry classification. Pleasingly, Encompass Health has a superior ROE than the average (15%) company in the Healthcare industry.

That’s clearly a positive. In my book, a high ROE almost always warrants a closer look. For example, I often check if insiders have been buying shares .

How Does Debt Impact ROE?

Companies usually need to invest money to grow their profits. That cash can come from retained earnings, issuing new shares (equity), or debt. In the first two cases, the ROE will capture this use of capital to grow. In the latter case, the debt used for growth will improve returns, but won’t affect the total equity. Thus the use of debt can improve ROE, albeit along with extra risk in the case of stormy weather, metaphorically speaking.

Combining Encompass Health’s Debt And Its 20% Return On Equity

Encompass Health does use a significant amount of debt to increase returns. It has a debt to equity ratio of 1.34. There’s no doubt the ROE is respectable, but it’s worth keeping in mind that metric is elevated by the use of debt. Debt does bring extra risk, so it’s only really worthwhile when a company generates some decent returns from it.

The Bottom Line On ROE

Return on equity is useful for comparing the quality of different businesses. In my book the highest quality companies have high return on equity, despite low debt. All else being equal, a higher ROE is better.

But when a business is high quality, the market often bids it up to a price that reflects this. The rate at which profits are likely to grow, relative to the expectations of profit growth reflected in the current price, must be considered, too. So you might want to check this FREE visualization of analyst forecasts for the company.