A Closer Look At Red Eléctrica Corporación, S.A.'s (BME:REE) Impressive ROE

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. To keep the lesson grounded in practicality, we'll use ROE to better understand Red Eléctrica Corporación, S.A. (BME:REE).

Return on equity or ROE is a key measure used to assess how efficiently a company's management is utilizing the company's capital. In short, ROE shows the profit each dollar generates with respect to its shareholder investments.

See our latest analysis for Red Eléctrica Corporación

How Do You Calculate Return On Equity?

The formula for return on equity is:

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

So, based on the above formula, the ROE for Red Eléctrica Corporación is:

19% = €700m ÷ €3.7b (Based on the trailing twelve months to March 2020).

The 'return' refers to a company's earnings over the last year. Another way to think of that is that for every €1 worth of equity, the company was able to earn €0.19 in profit.

Does Red Eléctrica Corporación 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. However, this method is only useful as a rough check, because companies do differ quite a bit within the same industry classification. As you can see in the graphic below, Red Eléctrica Corporación has a higher ROE than the average (8.2%) in the Electric Utilities industry.

That is a good sign. However, bear in mind that a high ROE doesn’t necessarily indicate efficient profit generation. 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 . You can see the 2 risks we have identified for Red Eléctrica Corporación by visiting our risks dashboard for free on our platform here.

How Does Debt Impact 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 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.

Combining Red Eléctrica Corporación's Debt And Its 19% Return On Equity

Red Eléctrica Corporación clearly uses a high amount of debt to boost returns, as it has a debt to equity ratio of 1.82. While its ROE is respectable, it is worth keeping in mind that there is usually a limit as to how much debt a company can use. Debt increases risk and reduces options for the company in the future, so you generally want to see some good returns from using it.

Conclusion

Return on equity is a useful indicator of the ability of a business to generate profits and return them to shareholders. In our books, the highest quality companies have high return on equity, despite low debt. If two companies have around the same level of debt to equity, and one has a higher ROE, I'd generally prefer the one with higher ROE.

But ROE is just one piece of a bigger puzzle, since high quality businesses often trade on high multiples of earnings. Profit growth rates, versus the expectations reflected in the price of the stock, are a particularly important to consider. So I think it may be worth checking this free report on 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.

Love or hate this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team@simplywallst.com.

This article by Simply Wall St is general in nature. 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. Thank you for reading.