Boasting A 29% Return On Equity, Is Netflix, Inc. (NASDAQ:NFLX) A Top Quality Stock?

<p class="canvas-atom canvas-text Mb(1.0em) Mb(0)–sm Mt(0.8em)–sm" type="text" content="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). To keep the lesson grounded in practicality, we'll use ROE to better understand Netflix, Inc. (NASDAQ:NFLX).” data-reactid=”28″>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). To keep the lesson grounded in practicality, we’ll use ROE to better understand Netflix, Inc. (NASDAQ:NFLX).

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 short, ROE shows the profit each dollar generates with respect to its shareholder investments.

<p class="canvas-atom canvas-text Mb(1.0em) Mb(0)–sm Mt(0.8em)–sm" type="text" content=" See our latest analysis for Netflix ” data-reactid=”30″>See our latest analysis for Netflix

How To Calculate Return On Equity?

<p class="canvas-atom canvas-text Mb(1.0em) Mb(0)–sm Mt(0.8em)–sm" type="text" content="ROE can be calculated by using the formula:” data-reactid=”36″>ROE can be calculated by using the formula:

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

So, based on the above formula, the ROE for Netflix is:

29% = US$2.7b ÷ US$9.3b (Based on the trailing twelve months to June 2020).

The ‘return’ is the yearly profit. One way to conceptualize this is that for each $1 of shareholders’ capital it has, the company made $0.29 in profit.

Does Netflix 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. Importantly, this is far from a perfect measure, because companies differ significantly within the same industry classification. As is clear from the image below, Netflix has a better ROE than the average (17%) in the Entertainment industry.

<p class="canvas-atom canvas-text Mb(1.0em) Mb(0)–sm Mt(0.8em)–sm" type="text" content="That's what we like to see. Bear in mind, a high ROE doesn't always mean superior financial performance. A higher proportion of debt in a company's capital structure may also result in a high ROE, where the high debt levels could be a huge risk . To know the 2 risks we have identified for Netflix visit our risks dashboard for free.” data-reactid=”55″>That’s what we like to see. Bear in mind, a high ROE doesn’t always mean superior financial performance. A higher proportion of debt in a company’s capital structure may also result in a high ROE, where the high debt levels could be a huge risk . To know the 2 risks we have identified for Netflix visit our risks dashboard for free.

How Does Debt Impact Return On Equity?

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 required for growth will boost returns, but will not impact the shareholders’ equity. That will make the ROE look better than if no debt was used.

Combining Netflix’s Debt And Its 29% Return On Equity

Netflix clearly uses a high amount of debt to boost returns, as it has a debt to equity ratio of 1.69. While no doubt that its ROE is impressive, we would have been even more impressed had the company achieved this with lower debt. Debt does bring extra risk, so it’s only really worthwhile when a company generates some decent returns from it.

Conclusion

Return on equity is one way we can compare its business quality of different companies. In our books, the highest quality companies have high return on equity, despite low debt. All else being equal, a higher ROE is better.

<p class="canvas-atom canvas-text Mb(1.0em) Mb(0)–sm Mt(0.8em)–sm" type="text" content="But ROE is just one piece of a bigger puzzle, since high quality businesses often trade on high multiples of earnings. 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 I think it may be worth checking this free report on analyst forecasts for the company.” data-reactid=”62″>But ROE is just one piece of a bigger puzzle, since high quality businesses often trade on high multiples of earnings. 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 I think it may be worth checking this free report on analyst forecasts for the company.

<p class="canvas-atom canvas-text Mb(1.0em) Mb(0)–sm Mt(0.8em)–sm" type="text" content="Of course, you might find a fantastic investment by looking elsewhere. So take a peek at this free list of interesting companies.” data-reactid=”63″>Of course, you might find a fantastic investment by looking elsewhere. So take a peek at this free list of interesting companies.