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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. By way of learning-by-doing, we'll look at ROE to gain a better understanding of American Tower Corporation (NYSE:AMT).
Return on equity or ROE is a key measure used to assess how efficiently a company's management is utilizing the company's capital. In short, ROE shows the profit each dollar generates with respect to its shareholder investments.
View our latest analysis for American Tower
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 American Tower is:
23% = US$2.9b ÷ US$12b (Based on the trailing twelve months to September 2022).
The 'return' is the amount earned after tax over the last twelve months. That means that for every $1 worth of shareholders' equity, the company generated $0.23 in profit.
Does American Tower Have A Good ROE?
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. As you can see in the graphic below, American Tower has a higher ROE than the average (6.9%) in the REITs industry.
That's clearly a positive. However, bear in mind that a high ROE doesn’t necessarily indicate efficient profit generation. Especially when a firm uses high levels of debt to finance its debt which may boost its ROE but the high leverage puts the company at risk. To know the 4 risks we have identified for American Tower visit our risks dashboard for free.
How Does Debt Impact ROE?
Most companies need money -- from somewhere -- to grow their profits. The cash for investment can come from prior year profits (retained earnings), issuing new shares, or borrowing. In the case of the first and second options, the ROE will reflect this use of cash, for growth. 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.
Combining American Tower's Debt And Its 23% Return On Equity
We think American Tower uses a significant amount of debt to maximize its returns, as it has a significantly higher debt to equity ratio of 3.11. So although the company has an impressive ROE, the company might not have been able to achieve this without the significant use of debt.