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 Terna – Rete Elettrica Nazionale Società per Azioni (BIT:TRN).
Over the last twelve months Terna – Rete Elettrica Nazionale Società per Azioni has recorded a ROE of 18%. One way to conceptualize this, is that for each €1 of shareholders’ equity it has, the company made €0.18 in profit.
How Do I Calculate ROE?
The formula for return on equity is:
Return on Equity = Net Profit ÷ Shareholders’ Equity
Or for Terna – Rete Elettrica Nazionale Società per Azioni:
18% = 701 ÷ €4.1b (Based on the trailing twelve months to September 2018.)
Most know that net profit is the total earnings after all expenses, but the concept of shareholders’ equity is a little more complicated. It is all earnings retained by the company, plus any capital paid in by shareholders. The easiest way to calculate shareholders’ equity is to subtract the company’s total liabilities from the total assets.
What Does Return On Equity 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, as a general rule, a high ROE is a good thing. That means ROE can be used to compare two businesses.
Does Terna – Rete Elettrica Nazionale Società per Azioni Have A Good ROE?
Arguably the easiest way to assess company’s ROE is to compare it with the average in its industry. However, this method is only useful as a rough check, because companies do differ quite a bit within the same industry classification. Pleasingly, Terna – Rete Elettrica Nazionale Società per Azioni has a superior ROE than the average (8.0%) company in the Electric Utilities industry.
That is a good sign. I usually take a closer look when a company has a better ROE than industry peers. For example, I often check if insiders have been buying shares .
Why You Should Consider Debt When Looking At ROE
Virtually all companies need money to invest in the business, to grow profits. The cash for investment can come from prior year profits (retained earnings), issuing new shares, or borrowing. In the first two cases, the ROE will capture this use of capital to grow. In the latter case, the debt used for growth will improve returns, but won’t affect the total equity. In this manner the use of debt will boost ROE, even though the core economics of the business stay the same.
Combining Terna – Rete Elettrica Nazionale Società per Azioni’s Debt And Its 18% Return On Equity
Terna – Rete Elettrica Nazionale Società per Azioni does use a significant amount of debt to increase returns. It has a debt to equity ratio of 2.37. Its ROE is quite good but, it would have probably been lower without 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.
Return on equity is one way we can compare the business quality of different companies. 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. The rate at which profits are likely to grow, relative to the expectations of profit growth reflected in the current price, must be considered, too. So you might want to check this FREE visualization of analyst forecasts for the company.
Of course Terna – Rete Elettrica Nazionale Società per Azioni may not be the best stock to buy. So you may wish to see this free collection of other companies that have high ROE 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 firstname.lastname@example.org.