In This Article:
One of the best investments we can make is in our own knowledge and skill set. With that in mind, this article will work through how we can use Return On Equity (ROE) to better understand a business. By way of learning-by-doing, we'll look at ROE to gain a better understanding of National Grid plc (LON:NG.).
Return on Equity or ROE is a test of how effectively a company is growing its value and managing investors’ money. Put another way, it reveals the company's success at turning shareholder investments into profits.
View our latest analysis for National Grid
How To Calculate Return On Equity?
The formula for return on equity is:
Return on Equity = Net Profit (from continuing operations) ÷ Shareholders' Equity
So, based on the above formula, the ROE for National Grid is:
4.8% = UK£1.7b ÷ UK£36b (Based on the trailing twelve months to September 2024).
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 £0.05 in profit.
Does National Grid 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, National Grid has a lower ROE than the average (11%) in the Integrated Utilities industry classification.
Unfortunately, that's sub-optimal. Although, we think that a lower ROE could still mean that a company has the opportunity to better its returns with the use of leverage, provided its existing debt levels are low. A company with high debt levels and low ROE is a combination we like to avoid given the risk involved. To know the 4 risks we have identified for National Grid visit our risks dashboard for free.
How Does Debt Impact ROE?
Companies usually need to invest money to grow their 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 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.
National Grid's Debt And Its 4.8% ROE
It's worth noting the high use of debt by National Grid, leading to its debt to equity ratio of 1.30. 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.