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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 Legal & General Group Plc (LON:LGEN), by way of a worked example.
Return on equity or ROE is an important factor to be considered by a shareholder because it tells them how effectively their capital is being reinvested. In other words, it is a profitability ratio which measures the rate of return on the capital provided by the company's shareholders.
View our latest analysis for Legal & General Group
How Do You Calculate Return On Equity?
ROE 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 Legal & General Group is:
7.5% = UK£292m ÷ UK£3.9b (Based on the trailing twelve months to June 2024).
The 'return' is the yearly profit. So, this means that for every £1 of its shareholder's investments, the company generates a profit of £0.07.
Does Legal & General Group Have A Good Return On Equity?
One simple way to determine if a company has a good return on equity is to compare it to the average for its industry. However, this method is only useful as a rough check, because companies do differ quite a bit within the same industry classification. As is clear from the image below, Legal & General Group has a lower ROE than the average (14%) in the Insurance industry.
Unfortunately, that's sub-optimal. That being said, a low ROE is not always a bad thing, especially if the company has low leverage as this still leaves room for improvement if the company were to take on more debt. A company with high debt levels and low ROE is a combination we like to avoid given the risk involved. You can see the 4 risks we have identified for Legal & General Group by visiting our risks dashboard for free on our platform here.
How Does Debt Impact ROE?
Virtually all companies need money to invest in the business, to grow profits. That cash can come from retained earnings, issuing new shares (equity), or debt. 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. Thus the use of debt can improve ROE, albeit along with extra risk in the case of stormy weather, metaphorically speaking.
Legal & General Group's Debt And Its 7.5% ROE
It appears that Legal & General Group makes extensive use of debt to improve its returns, because it has an alarmingly high debt to equity ratio of 7.23. The combination of a rather low ROE and high debt to equity is a negative, in our book.