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 Iliad SA (EPA:ILD), by way of a worked example.
Over the last twelve months Iliad has recorded a ROE of 11%. That means that for every €1 worth of shareholders’ equity, it generated €0.11 in profit.
See our latest analysis for Iliad
How Do I Calculate ROE?
The formula for ROE is:
Return on Equity = Net Profit ÷ Shareholders’ Equity
Or for Iliad:
11% = 371.873 ÷ €3.4b (Based on the trailing twelve months to June 2018.)
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 all the money paid into the company from shareholders, plus any earnings retained. 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 profit over the last twelve months. The higher the ROE, the more profit the company is making. So, as a general rule, a high ROE is a good thing. Clearly, then, one can use ROE to compare different companies.
Does Iliad Have A Good ROE?
One simple way to determine if a company has a good return on equity is to compare it to the average for its industry. Importantly, this is far from a perfect measure, because companies differ significantly within the same industry classification. As shown in the graphic below, Iliad has a lower ROE than the average (16%) in the telecom industry classification.
That certainly isn’t ideal. We’d prefer see an ROE above the industry average, but it might not matter if the company is undervalued. Still, shareholders might want to check if insiders have been selling.
How Does Debt Impact Return On Equity?
Companies usually need to invest money 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. Thus the use of debt can improve ROE, albeit along with extra risk in the case of stormy weather, metaphorically speaking.
Combining Iliad’s Debt And Its 11% Return On Equity
Iliad does use a significant amount of debt to increase returns. It has a debt to equity ratio of 1.21. while its ROE is respectable, it is worth keeping in mind that there is usually a limit to how much debt a company can use. 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.