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. To keep the lesson grounded in practicality, we'll use ROE to better understand Severn Trent PLC (LON:SVT).
Return on Equity or ROE is a test of how effectively a company is growing its value and managing investors’ money. In simpler terms, it measures the profitability of a company in relation to shareholder's equity.
Check out our latest analysis for Severn Trent
How Is ROE Calculated?
The formula for ROE is:
Return on Equity = Net Profit (from continuing operations) ÷ Shareholders' Equity
So, based on the above formula, the ROE for Severn Trent is:
7.6% = UK£140m ÷ UK£1.8b (Based on the trailing twelve months to March 2024).
The 'return' is the income the business earned over the last year. So, this means that for every £1 of its shareholder's investments, the company generates a profit of £0.08.
Does Severn Trent Have A Good Return On Equity?
By comparing a company's ROE with its industry average, we can get a quick measure of how good it is. Importantly, this is far from a perfect measure, because companies differ significantly within the same industry classification. As you can see in the graphic below, Severn Trent has a higher ROE than the average (3.9%) in the Water Utilities industry.
That's clearly a positive. 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 . You can see the 2 risks we have identified for Severn Trent by visiting our risks dashboard for free on our platform here.
The Importance Of Debt To Return On Equity
Most companies need money -- from somewhere -- to grow their profits. That cash can come from retained earnings, issuing new shares (equity), or debt. 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 required for growth will boost returns, but will not impact the shareholders' equity. In this manner the use of debt will boost ROE, even though the core economics of the business stay the same.
Combining Severn Trent's Debt And Its 7.6% Return On Equity
It seems that Severn Trent uses a huge volume of debt to fund the business, since it has an extremely high debt to equity ratio of 4.44. Most investors would need a low share price to be interested in a company with low ROE and high debt to equity.