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. We'll use ROE to examine Severn Trent PLC (LON:SVT), by way of a worked example.
Return on equity or ROE is a key measure used to assess how efficiently a company's management is utilizing the company's capital. In other words, it is a profitability ratio which measures the rate of return on the capital provided by the company's shareholders.
View our latest analysis for Severn Trent
How Is ROE Calculated?
ROE 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 Severn Trent is:
12% = UK£105m ÷ UK£861m (Based on the trailing twelve months to September 2023).
The 'return' is the yearly profit. That means that for every £1 worth of shareholders' equity, the company generated £0.12 in profit.
Does Severn Trent Have A Good ROE?
One simple way to determine if a company has a good return on equity is to compare it to the average for its industry. The limitation of this approach is that some companies are quite different from others, even within the same industry classification. The image below shows that Severn Trent has an ROE that is roughly in line with the Water Utilities industry average (11%).
So while the ROE is not exceptional, at least its acceptable. While at least the ROE is not lower than the industry, its still worth checking what role the company's debt plays as high debt levels relative to equity may also make the ROE appear high. If true, then it is more an indication of risk than the potential. Our risks dashboardshould have the 4 risks we have identified for Severn Trent.
Why You Should Consider Debt When Looking At ROE
Companies usually need to invest money to grow their profits. That cash can come from issuing shares, retained earnings, 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 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.
Severn Trent's Debt And Its 12% ROE
We think Severn Trent uses a significant amount of debt to maximize its returns, as it has a significantly higher debt to equity ratio of 8.96. Its ROE is respectable, but it's not so impressive once you consider all of the debt.