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. We'll use ROE to examine Maxis Berhad (KLSE:MAXIS), by way of a worked example.
Return on equity or ROE is an important factor to be considered by a shareholder because it tells them how effectively their capital is being reinvested. In short, ROE shows the profit each dollar generates with respect to its shareholder investments.
How Is ROE Calculated?
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 Maxis Berhad is:
20% = RM1.4b ÷ RM7.1b (Based on the trailing twelve months to September 2020).
The 'return' refers to a company's earnings over the last year. One way to conceptualize this is that for each MYR1 of shareholders' capital it has, the company made MYR0.20 in profit.
Does Maxis Berhad 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. Importantly, this is far from a perfect measure, because companies differ significantly within the same industry classification. As is clear from the image below, Maxis Berhad has a better ROE than the average (11%) in the Wireless Telecom industry.
That's what we like to see. However, bear in mind that a high ROE doesn’t necessarily indicate efficient profit generation. Especially when a firm uses high levels of debt to finance its debt which may boost its ROE but the high leverage puts the company at risk. To know the 2 risks we have identified for Maxis Berhad visit our risks dashboard for free.
How Does Debt Impact Return On Equity?
Companies usually need to invest money to grow their profits. That cash can come from issuing shares, retained earnings, 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 debt required for growth will boost returns, but will not impact the shareholders' equity. Thus the use of debt can improve ROE, albeit along with extra risk in the case of stormy weather, metaphorically speaking.
Combining Maxis Berhad's Debt And Its 20% Return On Equity
It's worth noting the high use of debt by Maxis Berhad, leading to its debt to equity ratio of 1.10. While its ROE is pretty respectable, the amount of debt the company is carrying currently is not ideal. 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 useful for comparing the quality of different businesses. 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. 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 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.
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