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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 Encompass Health Corporation (NYSE:EHC), 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. Put another way, it reveals the company's success at turning shareholder investments into profits.
View our latest analysis for Encompass Health
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 Encompass Health is:
19% = US$393m ÷ US$2.1b (Based on the trailing twelve months to March 2021).
The 'return' is the profit over the last twelve months. That means that for every $1 worth of shareholders' equity, the company generated $0.19 in profit.
Does Encompass Health 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. However, this method is only useful as a rough check, because companies do differ quite a bit within the same industry classification. You can see in the graphic below that Encompass Health has an ROE that is fairly close to the average for the Healthcare industry (18%).
That isn't amazing, but it is respectable. 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 so, this increases its exposure to financial risk. You can see the 3 risks we have identified for Encompass Health by visiting our risks dashboard for free on our platform here.
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 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.
Encompass Health's Debt And Its 19% ROE
It's worth noting the high use of debt by Encompass Health, leading to its debt to equity ratio of 1.59. While its ROE is pretty respectable, the amount of debt the company is carrying currently is not ideal. Debt does bring extra risk, so it's only really worthwhile when a company generates some decent returns from it.