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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 United Utilities Group PLC (LON:UU.).
ROE or return on equity is a useful tool to assess how effectively a company can generate returns on the investment it received from its shareholders. In simpler terms, it measures the profitability of a company in relation to shareholder's equity.
See our latest analysis for United Utilities Group
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 United Utilities Group is:
6.2% = UK£127m ÷ UK£2.1b (Based on the trailing twelve months to March 2024).
The 'return' is the profit over the last twelve months. That means that for every £1 worth of shareholders' equity, the company generated £0.06 in profit.
Does United Utilities 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. If you look at the image below, you can see United Utilities Group has a similar ROE to the average in the Water Utilities industry classification (6.2%).
That isn't amazing, but it is respectable. Although the ROE is similar to the industry, we should still perform further checks to see if the company's ROE is being boosted by high debt levels. If a company takes on too much debt, it is at higher risk of defaulting on interest payments. You can see the 3 risks we have identified for United Utilities Group by visiting our risks dashboard for free on our platform here.
The Importance Of Debt To Return On Equity
Companies usually need to invest money 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 used for growth will improve returns, but won't affect the total equity. That will make the ROE look better than if no debt was used.
United Utilities Group's Debt And Its 6.2% ROE
It seems that United Utilities Group uses a huge volume of debt to fund the business, since it has an extremely high debt to equity ratio of 4.84. We consider it to be a negative sign when a company has a rather low ROE despite a rather high debt to equity.