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Many investors are still learning about the various metrics that can be useful when analysing a stock. This article is for those who would like to learn about Return On Equity (ROE). To keep the lesson grounded in practicality, we'll use ROE to better understand Suncorp Group Limited (ASX:SUN).
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. Simply put, it is used to assess the profitability of a company in relation to its equity capital.
See our latest analysis for Suncorp Group
How Is ROE Calculated?
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 Suncorp Group is:
8.2% = AU$1.0b ÷ AU$13b (Based on the trailing twelve months to December 2019).
The 'return' refers to a company's earnings over the last year. So, this means that for every A$1 of its shareholder's investments, the company generates a profit of A$0.08.
Does Suncorp Group Have A Good ROE?
By comparing a company's ROE with its industry average, we can get a quick measure of how good it is. The limitation of this approach is that some companies are quite different from others, even within the same industry classification. As shown in the graphic below, Suncorp Group has a lower ROE than the average (11%) in the Insurance industry classification.
That's not what we like to see. 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 high debt company having a low ROE is a different story altogether and a risky investment in our books. To know the 2 risks we have identified for Suncorp Group visit our risks dashboard for free.
The Importance Of Debt To Return On Equity
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. Thus the use of debt can improve ROE, albeit along with extra risk in the case of stormy weather, metaphorically speaking.
Combining Suncorp Group's Debt And Its 8.2% Return On Equity
Suncorp Group does use a high amount of debt to increase returns. It has a debt to equity ratio of 1.86. The combination of a rather low ROE and significant use of debt is not particularly appealing. 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.