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While some investors are already well versed in financial metrics (hat tip), this article is for those who would like to learn about Return On Equity (ROE) and why it is important. We'll use ROE to examine AltaGas Ltd. (TSE:ALA), by way of a worked example.
Return on equity or ROE is a key measure used to assess how efficiently a company's management is utilizing the company's capital. Put another way, it reveals the company's success at turning shareholder investments into profits.
View our latest analysis for AltaGas
How Do You Calculate Return On Equity?
The formula for ROE is:
Return on Equity = Net Profit (from continuing operations) ÷ Shareholders' Equity
So, based on the above formula, the ROE for AltaGas is:
7.5% = CA$572m ÷ CA$7.7b (Based on the trailing twelve months to December 2020).
The 'return' refers to a company's earnings over the last year. Another way to think of that is that for every CA$1 worth of equity, the company was able to earn CA$0.07 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. The limitation of this approach is that some companies are quite different from others, even within the same industry classification. You can see in the graphic below that AltaGas has an ROE that is fairly close to the average for the Gas Utilities industry (9.2%).
That isn't amazing, but it is respectable. Although the ROE is similar to the industry, we should still perform further checks to see if the company's ROE is being boosted by high debt levels. If so, this increases its exposure to financial risk. To know the 4 risks we have identified for AltaGas visit our risks dashboard for free.
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 debt required for growth will boost returns, but will not impact the shareholders' equity. That will make the ROE look better than if no debt was used.
AltaGas' Debt And Its 7.5% ROE
AltaGas does use a high amount of debt to increase returns. It has a debt to equity ratio of 1.07. The combination of a rather low ROE and significant use of debt is not particularly appealing. Debt increases risk and reduces options for the company in the future, so you generally want to see some good returns from using it.