One of the best investments we can make is in our own knowledge and skill set. With that in mind, this article will work through how we can use Return On Equity (ROE) to better understand a business. To keep the lesson grounded in practicality, we’ll use ROE to better understand Entergy Corporation (NYSE:ETR).
ROE or return on equity is a useful tool to assess how effectively a company can generate returns on the investment it received from its shareholders. Put another way, it reveals the company’s success at shareholder investments into profits.
See our latest analysis for Entergy
How Is ROE Calculated?
Return on equity can be calculated by using the formula:
Return on Equity = Net Profit (from continuing operations) ÷ Shareholders’ Equity
So, based on the above formula, the ROE for Entergy is:
10% = US$1.2b ÷ US$12b (Based on the trailing twelve months to June 2022).
The ‘return’ refers to the company’s earnings over the last year. That means that for every $1 worth of shareholders’ equity, the company generated $0.10 in profit.
Does Entergy Have A Good ROE?
Arguably the easiest way to assess a company’s ROE is to compare it with the average in its industry. The limitation of this approach is that some companies are quite different from others, even within the same industry classification. If you look at the image below, you can see Entergy has a similar ROE to the average in the Electric Utilities industry classification (8.9%).
That isn’t amazing, but it is respectable. Even if the ROE is respectable when compared to the industry, it is worth checking if the firm’s ROE is being aided by high debt levels. If a company takes on too much debt, it is at higher risk of defaulting on interest payments. You can see the 2 risks we have identified for Entergy by visiting our risks dashboard for free on our platform here.
The Importance Of Debt To Return On Equity
Companies usually need to invest money 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 required for growth will boost returns, but will not impact the shareholders’ equity. In this manner the use of debt will boost ROE, even though the core economics of the business stay the same.
Entergy’s Debt And Its 10% ROE
Entergy clearly uses a high amount of debt to boost returns, as it has a debt to equity ratio of 2.23. The combination of a rather low ROE and significant use of debt is not particularly appealing. Debt does bring extra risk, so it’s only really worthwhile when a company generates some decent returns from it.
Return on equity is one way we can compare its business quality of different companies. Companies that can achieve high returns on equity without too much debt are generally of good quality. All else being equal, a higher ROE is better.
But when a business is high quality, the market often bids it up to a price that reflects this. The rate at which profits are likely to grow, relative to the expectations of profit growth reflected in the current price, must be considered, too. So you might want to check this FREE visualization of analyst forecasts for the company.
If you would prefer to check out another company — one with potentially superior financials — then do not miss this free list of interesting companies, that have HIGH return on equity 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 only using an unbiased methodology and our articles are not intended to be financial advice. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any stocks mentioned.
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