While some investors are already familiar with financial metrics (hat tip), this article is for those who want to learn more about return on equity (ROE) and why it is important. As a learning-by-doing, we’ll take a look at the ROE to better understand Legal & General Group Plc (LON: LGEN).
Return on equity or ROE is a key metric used to assess the efficiency with which the management of a business is using business capital. Simply put, it is used to assess a company’s profitability against its equity.
Check out our latest analysis for Legal & General Group
How do you calculate return on equity?
ROE can be calculated using the formula:
Return on equity = Net income (from continuing operations) ÷ Equity
Thus, based on the above formula, the ROE for Legal & General Group is:
20% = £ 2.1bn ÷ £ 10bn (based on the last twelve months to June 2021).
The “return” is the amount earned after tax over the past twelve months. Another way to think about this is that for every £ 1 worth of equity, the company was able to make £ 0.20 in profit.
Does Legal & General Group have a good return on equity?
Perhaps the easiest way to assess a company’s ROE is to compare it to the industry average. It is important to note that this measure is far from perfect, as companies differ considerably within a single industry classification. As you can see in the graph below, Legal & General Group has an above-average ROE (13%) for the insurance industry.
This is what we love to see. Keep in mind that a high ROE doesn’t always mean superior financial performance. A higher proportion of debt in a company’s capital structure can also result in high ROE, where high debt levels could represent a huge risk.
Why You Should Consider Debt When Looking At ROE
Most businesses need money – from somewhere – to increase their profits. This liquidity can come from the issuance of shares, retained earnings 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 used for growth will improve returns, but will not affect total equity. This will make the ROE better than if no debt was used.
The debt of the Legal & General group and its ROE of 20%
It appears that Legal & General Group is using a huge volume of debt to fund the business because it has an extremely high debt ratio of 5.18. His ROE is decent, but once I consider all the debt I’m not really impressed.
Return on equity is useful for comparing the quality of different companies. A business that can earn a high return on equity without going into debt could be considered a high quality business. If two companies have roughly the same level of debt to equity and one has a higher ROE, I would generally prefer the one with a higher ROE.
But ROE is only one piece of a bigger puzzle, as high-quality companies often trade at high earnings multiples. Especially important to consider are the growth rates of earnings, relative to expectations reflected in the share price. So you might want to check out this FREE visualization of analyst forecasts for the business.
Sure, you might find a fantastic investment looking elsewhere. So take a look at this free list of interesting companies.
This Simply Wall St article is general in nature. We provide commentary based on historical data and analyst forecasts using only unbiased methodology and our articles are not intended to be financial advice. It does not constitute a recommendation to buy or sell shares and does not take into account your goals or your financial situation. Our aim is to bring you long-term, targeted analysis based on fundamental data. Note that our analysis may not take into account the latest announcements from price sensitive companies or qualitative documents. Simply Wall St has no position in any of the stocks mentioned.
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