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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. By way of learning-by-doing, we'll look at ROE to gain a better understanding of AltaGas Ltd. (TSE:ALA).
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. In simpler terms, it measures the profitability of a company in relation to shareholder's equity.
See our latest analysis for AltaGas
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 AltaGas is:
6.4% = CA$527m ÷ CA$8.3b (Based on the trailing twelve months to September 2024).
The 'return' is the yearly profit. Another way to think of that is that for every CA$1 worth of equity, the company was able to earn CA$0.06 in profit.
Does AltaGas Have A Good Return On Equity?
By comparing a company's ROE with its industry average, we can get a quick measure of how good it is. Importantly, this is far from a perfect measure, because companies differ significantly within the same industry classification. If you look at the image below, you can see AltaGas has a similar ROE to the average in the Gas Utilities industry classification (7.9%).
That's neither particularly good, nor bad. Even if the ROE is respectable when compared to the industry, its 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 AltaGas by visiting our risks dashboard for free on our platform here.
The Importance Of Debt To Return On Equity
Most companies need money -- from somewhere -- to grow their profits. That cash can come from issuing shares, retained earnings, 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 debt used for growth will improve returns, but won't affect the total equity. That will make the ROE look better than if no debt was used.
AltaGas' Debt And Its 6.4% ROE
AltaGas clearly uses a high amount of debt to boost returns, as it has a debt to equity ratio of 1.25. The combination of a rather low ROE and significant use of debt is not particularly appealing. 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.