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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. To keep the lesson grounded in practicality, we'll use ROE to better understand Chorus Limited (NZSE:CNU).
Return on Equity or ROE is a test of how effectively a company is growing its value and managing investors’ money. In short, ROE shows the profit each dollar generates with respect to its shareholder investments.
Check out our latest analysis for Chorus
How Do You Calculate Return On Equity?
Return on equity 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 Chorus is:
2.3% = NZ$21m ÷ NZ$919m (Based on the trailing twelve months to December 2023).
The 'return' is the income the business earned over the last year. One way to conceptualize this is that for each NZ$1 of shareholders' capital it has, the company made NZ$0.02 in profit.
Does Chorus Have A Good Return On Equity?
Arguably the easiest way to assess company's ROE is to compare it with the average in 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, Chorus has a lower ROE than the average (5.2%) in the Telecom industry classification.
Unfortunately, that's sub-optimal. However, a low ROE is not always bad. If the company's debt levels are moderate to low, then there's still a chance that returns can be improved via the use of financial leverage. When a company has low ROE but high debt levels, we would be cautious as the risk involved is too high. Our risks dashboard should have the 4 risks we have identified for Chorus.
How Does Debt Impact ROE?
Most companies need money -- from somewhere -- 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. In this manner the use of debt will boost ROE, even though the core economics of the business stay the same.
Combining Chorus' Debt And Its 2.3% Return On Equity
We think Chorus uses a significant amount of debt to maximize its returns, as it has a significantly higher debt to equity ratio of 3.70. Most investors would need a low share price to be interested in a company with low ROE and high debt to equity.