One of the best investments we can make is in our own knowledge and skill set. With that in mind, this article will work through how we can use Return On Equity (ROE) to better understand a business. We’ll use ROE to examine innogy SE (FRA:IGY), by way of a worked example.
Over the last twelve months innogy has recorded a ROE of 11%. That means that for every €1 worth of shareholders’ equity, it generated €0.11 in profit.
How Do I Calculate Return On Equity?
The formula for return on equity is:
Return on Equity = Net Profit ÷ Shareholders’ Equity
Or for innogy:
11% = €811m ÷ €11.1b (Based on the trailing twelve months to June 2018.)
It’s easy to understand the ‘net profit’ part of that equation, but ‘shareholders’ equity’ requires further explanation. It is all the money paid into the company from shareholders, plus any earnings retained. The easiest way to calculate shareholders’ equity is to subtract the company’s total liabilities from the total assets.
What Does ROE Mean?
Return on Equity measures a company’s profitability against the profit it has kept for the business (plus any capital injections). The ‘return’ is the profit over the last twelve months. A higher profit will lead to a a higher ROE. So, all else being equal, a high ROE is better than a low one. That means ROE can be used to compare two businesses.
Does innogy Have A Good ROE?
By comparing a company’s ROE with its industry average, we can get a quick measure of how good it is. Importantly, this is far from a perfect measure, because companies differ significantly within the same industry classification. If you look at the image below, you can see innogy has a similar ROE to the average in the integrated utilities industry classification (11%).
That’s not overly surprising. ROE can change from year to year, based on decisions that have been made in the past. So savvy investors often note how long the CEO has been in that position.
Why You Should Consider Debt When Looking At ROE
Most companies need money — from somewhere — 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 use of debt will improve the returns, but will not change the equity. In this manner the use of debt will boost ROE, even though the core economics of the business stay the same.
innogy’s Debt And Its 11% ROE
innogy clearly uses a significant amount debt to boost returns, as it has a debt to equity ratio of 1.74. 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 some extra risk, so it’s only really worthwhile when a company generates some decent returns from it.
But It’s Just One Metric
Return on equity is one way we can compare the business quality of different companies. A company that can achieve a high return on equity without debt could be considered a high quality business. All else being equal, a higher ROE is better.
Having said that, while ROE is a useful indicator of business quality, you’ll have to look at a whole range of factors to determine the right price to buy a stock. It is important to consider other factors, such as future profit growth — and how much investment is required going forward. So you might want to take a peek at this data-rich interactive graph of forecasts for the company.
Of course, you might find a fantastic investment by looking elsewhere. So take a peek at this free list of interesting companies.
To help readers see past the short term volatility of the financial market, we aim to bring you a long-term focused research analysis purely driven by fundamental data. Note that our analysis does not factor in the latest price-sensitive company announcements.
The author is an independent contributor and at the time of publication had no position in the stocks mentioned. For errors that warrant correction please contact the editor at email@example.com.