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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). We'll use ROE to examine Energy Action Limited (ASX:EAX), by way of a worked example.
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. Simply put, it is used to assess the profitability of a company in relation to its equity capital.
Check out our latest analysis for Energy Action
How Do You Calculate Return On Equity?
The formula for ROE is:
Return on Equity = Net Profit (from continuing operations) ÷ Shareholders' Equity
So, based on the above formula, the ROE for Energy Action is:
25% = AU$584k ÷ AU$2.3m (Based on the trailing twelve months to June 2024).
The 'return' is the profit over the last twelve months. That means that for every A$1 worth of shareholders' equity, the company generated A$0.25 in profit.
Does Energy Action Have A Good ROE?
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 is clear from the image below, Energy Action has a better ROE than the average (16%) in the Professional Services industry.
That is a good sign. With that said, a high ROE doesn't always indicate high profitability. A higher proportion of debt in a company's capital structure may also result in a high ROE, where the high debt levels could be a huge risk . To know the 5 risks we have identified for Energy Action visit our risks dashboard for free.
How Does Debt Impact Return On Equity?
Virtually all companies need money to invest in the business, to grow profits. That cash can come from issuing shares, retained earnings, 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. That will make the ROE look better than if no debt was used.
Energy Action's Debt And Its 25% ROE
It's worth noting the high use of debt by Energy Action, leading to its debt to equity ratio of 2.01. Its ROE is pretty impressive but, it would have probably been lower without the use of debt. 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.