Many investors are still educating themselves about the various metrics that can be useful when analyzing a stock. This article is for those who want to learn more about return on equity (ROE). To keep the lesson grounded in practice, we will use the ROE to better understand Red Eléctrica Corporación, SA (BME: REE).
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.
See our latest review for Red Eléctrica Corporación
How to calculate return on equity?
The return on equity formula is:
Return on equity = Net income (from continuing operations) ÷ Equity
Thus, based on the above formula, the ROE of Red Eléctrica Corporación is:
18% = 639 million euros ÷ 3.5 billion euros (based on the last twelve months up to June 2021).
The “return” is the income the business has earned over the past year. This therefore means that for every € 1 invested by its shareholder, the company generates a profit of € 0.18.
Does Red Eléctrica Corporación have a good ROE?
A simple way to determine if a company has a good return on equity is to compare it to the average in its industry. However, this method is only useful as a rough check, as companies differ a lot within a single industry classification. As you can see in the graph below, Red Eléctrica Corporación has an above-average ROE (14%) for the electric utility sector.
It’s a good sign. That said, high ROE doesn’t always indicate high profitability. 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. You can see the 2 risks that we have identified for Red Eléctrica Corporación by visiting our risk dashboard for free on our platform here.
What is the impact of debt on 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 first and second cases, the ROE will reflect this use of cash for investing in the business. 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.
Red Eléctrica Corporación’s debt and its 18% ROE
Red Eléctrica Corporación clearly uses a high amount of debt to increase returns, as it has a debt-to-equity ratio of 1.99. While its ROE is respectable, it should be borne in mind that there is usually a limit on how much debt a business can use. Leverage increases risk and reduces options for the business in the future, so you usually want to get good returns using it.
Return on equity is a way to compare the quality of the business of different companies. In our books, the highest quality companies have a high return on equity, despite low leverage. All other things being equal, a higher ROE is preferable.
But ROE is only one piece of a bigger puzzle, as high-quality companies often trade at high earnings multiples. The rate at which earnings are likely to grow, relative to earnings growth expectations reflected in the current price, should also be considered. So you might want to check out this FREE visualization of analyst forecasts for the business.
If you would rather consult with another company – one with potentially superior finances – then don’t miss this free list of interesting companies, which have a HIGH return on equity and low leverage.
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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 the mentioned stocks.
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