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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). To keep the lesson grounded in practicality, we'll use ROE to better understand EnBW Energie Baden-Württemberg AG (ETR:EBK).
EnBW Energie Baden-Württemberg has a ROE of 4.7%, based on the last twelve months. One way to conceptualize this, is that for each €1 of shareholders' equity it has, the company made €0.05 in profit.
View our latest analysis for EnBW Energie Baden-Württemberg
How Do You Calculate ROE?
The formula for return on equity is:
Return on Equity = Net Profit ÷ Shareholders' Equity
Or for EnBW Energie Baden-Württemberg:
4.7% = €154m ÷ €5.4b (Based on the trailing twelve months to September 2019.)
Most know that net profit is the total earnings after all expenses, but the concept of shareholders' equity is a little more complicated. It is the capital paid in by shareholders, plus any retained earnings. You can calculate shareholders' equity by subtracting the company's total liabilities from its total assets.
What Does ROE Signify?
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. A higher profit will lead to a higher ROE. So, all else being equal, a high ROE is better than a low one. That means ROE can be used to compare two businesses.
Does EnBW Energie Baden-Württemberg Have A Good ROE?
Arguably the easiest way to assess company's ROE is to compare it with the average in its industry. However, this method is only useful as a rough check, because companies do differ quite a bit within the same industry classification. As shown in the graphic below, EnBW Energie Baden-Württemberg has a lower ROE than the average (7.9%) in the Electric Utilities industry classification.
That's not what we like to see. It is better when the ROE is above industry average, but a low one doesn't necessarily mean the business is overpriced. Still, shareholders might want to check if insiders have been selling.
The Importance Of Debt To Return On Equity
Companies usually need to invest money to grow their profits. The cash for investment can come from prior year profits (retained earnings), issuing new shares, or borrowing. In the first two cases, the ROE will capture this use of capital to grow. In the latter case, the use of debt will improve the returns, but will not change the equity. In this manner the use of debt will boost ROE, even though the core economics of the business stay the same.