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 APA Group (ASX:APA), by way of a worked example.
Return on Equity or ROE is a test of how effectively a company is growing its value and managing investorsâ money. In simpler terms, it measures the profitability of a company in relation to shareholder's equity.
See our latest analysis for APA Group
How Is ROE Calculated?
The formula for return on equity is:
Return on Equity = Net Profit (from continuing operations) á Shareholders' Equity
So, based on the above formula, the ROE for APA Group is:
31% = AU$1.1b á AU$3.6b (Based on the trailing twelve months to December 2023).
The 'return' is the yearly profit. So, this means that for every A$1 of its shareholder's investments, the company generates a profit of A$0.31.
Does APA Group 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, APA Group has a superior ROE than the average (10%) in the Gas Utilities industry.
That's clearly a positive. However, bear in mind that a high ROE doesnât necessarily indicate efficient profit generation. Aside from changes in net income, a high ROE can also be the outcome of high debt relative to equity, which indicates risk. You can see the 4 risks we have identified for APA Group by visiting our risks dashboard for free on our platform here.
Why You Should Consider Debt When Looking At ROE
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 used for growth will improve returns, but won't affect the total equity. That will make the ROE look better than if no debt was used.
Combining APA Group's Debt And Its 31% Return On Equity
We think APA Group uses a significant amount of debt to maximize its returns, as it has a significantly higher debt to equity ratio of 3.64. Its ROE is clearly quite good, but it seems to be boosted by the significant use of debt by the company.
Summary
Return on equity is useful for comparing the quality of different businesses. In our books, the highest quality companies have high return on equity, despite low debt. If two companies have the same ROE, then I would generally prefer the one with less debt.
But when a business is high quality, the market often bids it up to a price that reflects this. Profit growth rates, versus the expectations reflected in the price of the stock, are a particularly important to consider. So you might want to check this FREE visualization of analyst 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.
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This article by Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any stocks mentioned.
Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team@simplywallst.com
About ASX:APA
Undervalued with solid track record and pays a dividend.
