Can Red Eléctrica Corporación, S.A. (BME:REE) Maintain Its Strong Returns?

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

Red Eléctrica Corporación has a ROE of 21%, based on the last twelve months. Another way to think of that is that for every €1 worth of equity in the company, it was able to earn €0.21.

See our latest analysis for Red Eléctrica Corporación

How Do I Calculate Return On Equity?

The formula for ROE is:

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

Or for Red Eléctrica Corporación:

21% = €713m ÷ €3.4b (Based on the trailing twelve months to September 2019.)

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. You can calculate shareholders' equity by subtracting the company's total liabilities from its total assets.

What Does ROE Mean?

ROE measures a company's profitability against the profit it retains, and any outside investments. The 'return' is the yearly profit. 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. Clearly, then, one can use ROE to compare different companies.

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. Importantly, this is far from a perfect measure, because companies differ significantly within the same industry classification. As is clear from the image below, Red Eléctrica Corporación has a better ROE than the average (8.4%) in the Electric Utilities industry.

That's what I like to see. We think a high ROE, alone, is usually enough to justify further research into a company. For example you might check if insiders are buying shares.

How Does Debt Impact 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 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.

Red Eléctrica Corporación's Debt And Its 21% ROE

It's worth noting the significant use of debt by Red Eléctrica Corporación, leading to its debt to equity ratio of 1.63. I think the ROE is impressive, but it would have been assisted by the use of debt. Debt increases risk and reduces options for the company in the future, so you generally want to see some good returns from using it.

The Key Takeaway

Return on equity is useful for comparing the quality of different businesses. In my book the highest quality companies have high return on equity, despite low debt. All else being equal, a higher ROE is better.

But when a business is high quality, the market often bids it up to a price that reflects this. It is important to consider other factors, such as future profit growth -- and how much investment is required going forward. 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.

If you spot an error that warrants correction, please contact the editor at 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. Simply Wall St has no position in the stocks mentioned.

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