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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). We'll use ROE to examine Ashtead Group plc (LON:AHT), 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. In short, ROE shows the profit each dollar generates with respect to its shareholder investments.
See our latest analysis for Ashtead Group
How Is ROE Calculated?
The formula for ROE is:
Return on Equity = Net Profit (from continuing operations) ÷ Shareholders' Equity
So, based on the above formula, the ROE for Ashtead Group is:
27% = US$1.6b ÷ US$5.7b (Based on the trailing twelve months to January 2023).
The 'return' is the yearly profit. That means that for every £1 worth of shareholders' equity, the company generated £0.27 in profit.
Does Ashtead Group 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. As you can see in the graphic below, Ashtead Group has a higher ROE than the average (14%) in the Trade Distributors industry.
That is a good sign. 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 .
How Does Debt Impact ROE?
Virtually all companies need money to invest in the business, to grow 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. That will make the ROE look better than if no debt was used.
Ashtead Group's Debt And Its 27% ROE
Ashtead Group does use a high amount of debt to increase returns. It has a debt to equity ratio of 1.14. 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. Debt does bring extra risk, so it's only really worthwhile when a company generates some decent returns from it.
Summary
Return on equity is useful for comparing the quality of different businesses. A company that can achieve a high return on equity without debt could be considered a high quality business. If two companies have around the same level of debt to equity, and one has a higher ROE, I'd generally prefer the one with higher ROE.