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 Telford Homes Plc (LON:TEF).
Over the last twelve months Telford Homes has recorded a ROE of 16%. That means that for every £1 worth of shareholders’ equity, it generated £0.16 in profit.
Check out our latest analysis for Telford Homes
How Do I Calculate ROE?
The formula for return on equity is:
Return on Equity = Net Profit ÷ Shareholders’ Equity
Or for Telford Homes:
16% = UK£37m ÷ UK£231m (Based on the trailing twelve months to March 2018.)
Most know that net profit is the total earnings after all expenses, but the concept of shareholders’ equity is a little more complicated. It is all earnings retained by the company, plus any capital paid in by shareholders. You can calculate shareholders’ equity by subtracting the company’s total liabilities from its total assets.
What Does ROE Mean?
ROE measures a company’s profitability against the profit it retains, and any outside investments. The ‘return’ is the yearly profit. A higher profit will lead to a a higher ROE. So, all else equal, investors should like a high ROE. That means ROE can be used to compare two businesses.
Does Telford Homes 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. However, this method is only useful as a rough check, because companies do differ quite a bit within the same industry classification. The image below shows that Telford Homes has an ROE that is roughly in line with the consumer durables industry average (16%).
That’s neither particularly good, nor bad. Generally it will take a while for decisions made by leadership to impact the ROE. So savvy investors often note how long the CEO has been in that position.
How Does Debt Impact 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 first two cases, the ROE will capture this use of capital to grow. In the latter case, the use of debt will improve the returns, but will not change the equity. In this manner the use of debt will boost ROE, even though the core economics of the business stay the same.
Combining Telford Homes’s Debt And Its 16% Return On Equity
Although Telford Homes does use debt, its debt to equity ratio of 0.49 is still low. The fact that it achieved a fairly good ROE with only modest debt suggests the business might be worth putting on your watchlist. Conservative use of debt to boost returns is usually a good move for shareholders, though it does leave the company more exposed to interest rate rises.