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 Booz Allen Hamilton Holding Corporation (NYSE:BAH), by way of a worked example.

Return on Equity or ROE is a test of how effectively a company is growing its value and managing investors’ money. In other words, it is a profitability ratio which measures the rate of return on the capital provided by the company's shareholders.

View our latest analysis for Booz Allen Hamilton Holding

How Do You Calculate Return On Equity?

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 Booz Allen Hamilton Holding is:

53% = US$516m ÷ US$972m (Based on the trailing twelve months to September 2020).

The 'return' refers to a company's earnings over the last year. One way to conceptualize this is that for each $1 of shareholders' capital it has, the company made $0.53 in profit.

Does Booz Allen Hamilton Holding Have A Good Return On Equity?

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. As is clear from the image below, Booz Allen Hamilton Holding has a better ROE than the average (14%) in the IT industry.

That's what we like to see. Bear in mind, a high ROE doesn't always mean superior financial performance. A higher proportion of debt in a company's capital structure may also result in a high ROE, where the high debt levels could be a huge risk . You can see the 2 risks we have identified for Booz Allen Hamilton Holding by visiting our risks dashboard for free on our platform here.

How Does Debt Impact 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 and second cases, the ROE will reflect this use of cash for investment in the business. In the latter case, the use of debt will improve the returns, but will not change the equity. That will make the ROE look better than if no debt was used.

Combining Booz Allen Hamilton Holding's Debt And Its 53% Return On Equity

Booz Allen Hamilton Holding does use a high amount of debt to increase returns. It has a debt to equity ratio of 2.52. There's no doubt the ROE is impressive, but it's worth keeping in mind that the metric could have been lower if the company were to reduce its debt. 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.