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).We’ll use ROE to examine Telstra Corporation Limited (ASX:TLS), by way of a worked example.
Our data shows Telstra has a return on equity of 24% for the last year.One way to conceptualize this, is that for each A$1 of shareholders’ equity it has, the company made A$0.24 in profit.
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How Do I Calculate Return On Equity?
The formula for ROE is:
Return on Equity = Net Profit ÷ Shareholders’ Equity
Or for Telstra:
24% = 3563 ÷ AU$15b (Based on the trailing twelve months to June 2018.)
It’s easy to understand the ‘net profit’ part of that equation, but ‘shareholders’ equity’ requires further explanation.It is all the money paid into the company from shareholders, plus any earnings retained.The easiest way to calculate shareholders’ equity is to subtract the company’s total liabilities from the total assets.
What Does Return On Equity Mean?
Return on Equity measures a company’s profitability against the profit it has kept for the business (plus any capital injections).The ‘return’ is the amount earned after tax over the last twelve months.The higher the ROE, the more profit the company is making.So, all else being equal, a high ROE is better than a low one.Clearly, then, one can use ROE to compare different companies.
Does Telstra Have A Good ROE?
One simple way to determine if a company has a good return on equity is to compare it to the average for its industry.Importantly, this is far from a perfect measure, because companies differ significantly within the same industry classification.Pleasingly, Telstra has a superior ROE than the average (14%) company in the Telecom industry.
That’s clearly a positive.In my book, a high ROE almost always warrants a closer look.For example you might check if insiders are buying shares.
The Importance Of Debt To Return On Equity
Most companies need money — from somewhere — to grow their profits.That cash can come from retained earnings, issuing new shares (equity), or debt.In the first two cases, the ROE will capture this use of capital to grow.In the latter case, the debt used for growth will improve returns, but won’t affect the total equity.In this manner the use of debt will boost ROE, even though the core economics of the business stay the same.
Telstra’s Debt And Its 24% ROE
Telstra clearly uses a significant amount debt to boost returns, as it has a debt to equity ratio of 1.15.There’s no doubt its ROE is impressive, but the company appears to use its debt to boost that metric.Investors should think carefully about how a company might perform if it was unable to borrow so easily, because credit markets do change over time.
The Bottom Line On ROE
Return on equity is a useful indicator of the ability of a business to generate profits and return them to shareholders.Companies that can achieve high returns on equity without too much debt are generally of good quality.If two companies have around the same level of debt to equity, and one has a higher ROE, I’d generally prefer the one with higher ROE.
Having said that, while ROE is a useful indicator of business quality, you’ll have to look at a whole range of factors to determine the right price to buy a stock.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 freereport on analyst forecasts for the company.
Of course, you might find a fantastic investment by looking elsewhere. So take a peek at this freelist of interesting companies.
To help readers see past the short term volatility of the financial market, we aim to bring you a long-term focused research analysis purely driven by fundamental data. Note that our analysis does not factor in the latest price-sensitive company announcements.
The author is an independent contributor and at the time of publication had no position in the stocks mentioned. For errors that warrant correction please contact the editor at email@example.com.