While some investors are already familiar with financial metrics (hat tip), this article is for those who want to learn about return on equity (ROE) and its importance. As a practical example, let's look at Canadian Utilities Limited (TSE:CU) using ROE.
ROE or return on equity is a useful tool for evaluating how effectively a company can generate returns on the investment it receives from its shareholders. In other words, it is a profitability ratio that measures the rate of return on the capital provided by a company's shareholders.
See our latest analysis for Canadian Utilities
How do you calculate return on equity?
Return on equity can be calculated using the following formula:
Return on equity = Net income (from continuing operations) ÷ Shareholders' equity
So, based on the above formula, the ROE for Canadian Utilities is:
9.7% = CA$676 million ÷ CA$7 billion (based on trailing twelve months to September 2023).
“Return” refers to a company's earnings over the past year. Another way to think of it is that for every CA$1 worth of stock, the company allowed him to earn a profit of CA$0.10.
Do Canadian utilities have a high return on equity?
One easy way to determine whether a company has a high return on equity is to compare it to the average for its industry. A limitation of this approach is that some companies are very different from others, even within the same industry classification. In the image below, we can see that Canadian Utilities has a similar ROE to the average (9.3%) in the General Utilities industry classification.
That's neither particularly good nor bad. Even if a company's ROE is respectable compared to its industry, it's worth checking whether a company's ROE is supported by high levels of debt. If so, your exposure to financial risks increases. To learn about the two risks we have identified for Canadian utilities, visit our risks dashboard for free.
What impact does debt have on ROE?
Businesses usually need to invest money to increase their profits. That cash may come from issuing equity, retained earnings, or debt. In the first and his second cases, ROE reflects the use of cash for investment in the business. In the latter case, using debt increases returns but does not change equity. If we do that, our ROE will be better than if we didn't take out debt.
Canadian utility debt and its 9.7% ROE
Canadian utilities use large amounts of debt to increase profits. The debt-to-equity ratio is 1.51. The combination of fairly low ROE and significant debt is not particularly attractive. Debt brings extra risk, so debt is only really worth it if a company generates some profit from it.
summary
Return on equity helps you compare the quality of different businesses. According to our book, the highest quality companies have a higher return on equity despite having less debt. If two companies have the same ROE, I generally choose the one with less debt.
That said, while ROE is a useful indicator of the quality of a business, you need to consider a variety of factors to determine the right price to buy a stock. You should also consider the rate at which earnings are likely to grow compared to the expected earnings growth reflected in the current price. So you might want to take a peek at this data-rich, interactive graph depicting forecasts for this company.
of course Canadian Utilities may not be the best stock to buy.So you might want to see this free A collection of other companies with high ROE and low debt.
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This article by Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts using only unbiased methodologies, and articles are not intended to be financial advice. This is not a recommendation to buy or sell any stock, and does not take into account your objectives or financial situation. We aim to provide long-term, focused analysis based on fundamental data. Note that our analysis may not factor in the latest announcements or qualitative material from price-sensitive companies. Simply Wall St has no position in any stocks mentioned.
