Many investors are still learning the different metrics that can be helpful when analyzing a stock. This article is for those who want to know more about return on equity (ROE). Learning by doing, we will examine ROE to better understand American Tower Corporation (NYSE: AMT).
Return on equity or ROE is a key metric used to gauge how effectively a company’s management is using the company’s capital. In simpler terms, it measures a company’s profitability relative to equity.
Check out our latest analysis for American Tower
How to calculate return on equity?
The ROE formula is:
Return on equity = Net income (from continuing operations) ÷ Equity
So, based on the above formula, the ROE for American Tower is:
28% = US$2.6 billion ÷ US$9.3 billion (based on trailing 12 months to March 2022).
“Yield” is the income the business has earned over the past year. This means that for every dollar of shareholders’ equity, the company generated $0.28 in profit.
Does American Tower 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 for its industry. The limitation of this approach is that some companies are quite different from others, even within the same industrial classification. Fortunately, American Tower has an above-average ROE (6.5%) for the REIT industry.
This is clearly a positive point. However, keep in mind that a high ROE does not necessarily indicate efficient profit generation. A higher proportion of debt in a company’s capital structure can also result in a high ROE, where high debt levels could be a huge risk. Our risk dashboard should contain the 3 risks we have identified for American Tower.
The Importance of Debt to Return on Equity
Companies generally need to invest money to increase their profits. The money for the investment can come from the previous year’s earnings (retained earnings), from issuing new shares or from borrowing. In the case of the first and second options, the ROE will reflect this use of cash, for growth. In the latter case, debt used for growth will improve returns, but will not affect total equity. Thus, the use of debt can improve ROE, but with an additional risk in the event of a storm, metaphorically speaking.
Combine American Tower’s debt and its 28% return on equity
It appears that American Tower is using debt heavily to enhance its returns, as it has an alarming debt-to-equity ratio of 4.70. While its ROE is undoubtedly quite impressive, it could give the wrong impression about the company’s returns given that its huge debt could boost those returns.
Return on equity is useful for comparing the quality of different companies. Companies that can earn high returns on equity without too much debt are generally of good quality. If two companies have roughly the same level of debt and one has a higher ROE, I generally prefer the one with a higher ROE.
But ROE is only one piece of a larger puzzle, as high-quality companies often trade on high earnings multiples. Earnings growth rates, relative to expectations reflected in the share price, are particularly important to consider. So I think it’s worth checking it out free analyst forecast report for the company.
If you’d rather check out another company – one with potentially superior finances – then don’t miss this free list of attractive companies, which have a high return on equity and low debt.
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This Simply Wall St article is general in nature. We provide commentary based on historical data and analyst forecasts only using unbiased methodology and our articles are not intended to be financial advice. It is not a recommendation to buy or sell stocks and does not take into account your objectives or financial situation. Our goal is to bring you targeted long-term analysis based on fundamental data. Note that our analysis may not take into account the latest announcements from price-sensitive companies or qualitative materials. Simply Wall St has no position in the stocks mentioned.