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 Enbridge Income Fund Holdings Inc (TSE:ENF), by way of a worked example.
Enbridge Income Fund Holdings has a ROE of 19%, based on the last twelve months. That means that for every CA$1 worth of shareholders’ equity, it generated CA$0.19 in profit.
How Do You Calculate ROE?
The formula for ROE is:
Return on Equity = Net Profit ÷ Shareholders’ Equity
Or for Enbridge Income Fund Holdings:
19% = CA$1.0b ÷ CA$5.5b (Based on the trailing twelve months to June 2018.)
Most readers would understand what net profit is, but it’s worth explaining the concept of shareholders’ equity. It is all the money paid into the company from shareholders, plus any earnings retained. You can calculate shareholders’ equity by subtracting the company’s total liabilities from its 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 amount earned after tax over the last twelve months. The higher the ROE, the more profit the company is making. So, all else being equal, a high ROE is better than a low one. That means it can be interesting to compare the ROE of different companies.
Does Enbridge Income Fund Holdings 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. As is clear from the image below, Enbridge Income Fund Holdings has a better ROE than the average (5.7%) in the oil and gas industry.
That’s clearly a positive. In my book, a high ROE almost always warrants a closer look. For example you might check if insiders are buying shares.
The Importance Of Debt To Return On Equity
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 and second cases, the ROE will reflect this use of cash for investment in the business. 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.
Enbridge Income Fund Holdings’s Debt And Its 19% ROE
One positive for shareholders is that Enbridge Income Fund Holdings does not have any net debt! Its ROE already suggests it is a good business, but the fact it has achieved this — and doesn’t borrowings — makes it worthy of further consideration, in my view. After all, with cash on the balance sheet, a company has a lot more optionality in good times and bad.
The Key Takeaway
Return on equity is one way we can compare the business quality of different companies. Companies that can achieve high returns on equity without too much debt are generally of good quality. All else being equal, a higher ROE is better.
But ROE is just one piece of a bigger puzzle, since high quality businesses often trade on high multiples of earnings. 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.
If you would prefer check out another company — one with potentially superior financials — then do not miss this free list of interesting companies, that have HIGH return on equity and low debt.
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.