Stock Analysis

# With A Return On Equity Of 9.6%, Has American Electric Power Company, Inc.'s (NASDAQ:AEP) Management Done Well?

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Many investors are still learning about the various metrics that can be useful when analysing a stock. This article is for those who would like to learn about Return On Equity (ROE). By way of learning-by-doing, we'll look at ROE to gain a better understanding of American Electric Power Company, Inc. (NASDAQ:AEP).

Return on Equity or ROE is a test of how effectively a company is growing its value and managing investors’ money. In other words, it is a profitability ratio which measures the rate of return on the capital provided by the company's shareholders.

See our latest analysis for American Electric Power Company

## How Do You Calculate Return On Equity?

ROE can be calculated by using the formula:

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

So, based on the above formula, the ROE for American Electric Power Company is:

9.6% = US\$2.3b ÷ US\$24b (Based on the trailing twelve months to December 2022).

The 'return' is the amount earned after tax over the last twelve months. That means that for every \$1 worth of shareholders' equity, the company generated \$0.10 in profit.

## Does American Electric Power Company 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. The limitation of this approach is that some companies are quite different from others, even within the same industry classification. You can see in the graphic below that American Electric Power Company has an ROE that is fairly close to the average for the Electric Utilities industry (8.4%).

That's neither particularly good, nor bad. While at least the ROE is not lower than the industry, its still worth checking what role the company's debt plays as high debt levels relative to equity may also make the ROE appear high. If true, then it is more an indication of risk than the potential. You can see the 3 risks we have identified for American Electric Power Company by visiting our risks dashboard for free on our platform here.

## How Does Debt Impact Return On Equity?

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 use of debt will improve the returns, but will not change the equity. That will make the ROE look better than if no debt was used.

## Combining American Electric Power Company's Debt And Its 9.6% Return On Equity

American Electric Power Company does use a high amount of debt to increase returns. It has a debt to equity ratio of 1.65. With a fairly low ROE, and significant use of debt, it's hard to get excited about this business at the moment. Debt does bring extra risk, so it's only really worthwhile when a company generates some decent returns from it.

## Conclusion

Return on equity is useful for comparing the quality of different businesses. A company that can achieve a high return on equity without debt could be considered a high quality business. If two companies have the same ROE, then I would generally prefer the one with less debt.

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 American Electric Power Company 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.

### Valuation is complex, but we're helping make it simple.

Find out whether American Electric Power Company is potentially over or undervalued by checking out our comprehensive analysis, which includes fair value estimates, risks and warnings, dividends, insider transactions and financial health.

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