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While some investors are already well versed in financial metrics (hat tip), this article is for those who would like to learn about Return On Equity (ROE) and why it is important. We'll use ROE to examine Canadian National Railway Company (TSE:CNR), 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.
Check out our latest analysis for Canadian National Railway
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 Canadian National Railway is:
28% = CA$5.4b ÷ CA$19b (Based on the trailing twelve months to September 2024).
The 'return' is the yearly profit. One way to conceptualize this is that for each CA$1 of shareholders' capital it has, the company made CA$0.28 in profit.
Does Canadian National Railway 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. Pleasingly, Canadian National Railway has a superior ROE than the average (15%) in the Transportation industry.
That's what we like to see. However, bear in mind that a high ROE doesn’t necessarily indicate efficient profit generation. Aside from changes in net income, a high ROE can also be the outcome of high debt relative to equity, which indicates risk.
How Does Debt Impact ROE?
Most companies need money -- from somewhere -- to grow their profits. The cash for investment can come from prior year profits (retained earnings), issuing new shares, or borrowing. 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. That will make the ROE look better than if no debt was used.
Combining Canadian National Railway's Debt And Its 28% Return On Equity
It's worth noting the high use of debt by Canadian National Railway, leading to its debt to equity ratio of 1.06. Its ROE is pretty impressive but, it would have probably been lower without the use of debt. Debt increases risk and reduces options for the company in the future, so you generally want to see some good returns from using it.