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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 American Water Works Company, Inc. (NYSE:AWK), by way of a worked example.
ROE or return on equity is a useful tool to assess how effectively a company can generate returns on the investment it received from its shareholders. In short, ROE shows the profit each dollar generates with respect to its shareholder investments.
Check out our latest analysis for American Water Works Company
How To Calculate Return On Equity?
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 American Water Works Company is:
11% = US$749m ÷ US$6.7b (Based on the trailing twelve months to June 2021).
The 'return' is the yearly profit. That means that for every $1 worth of shareholders' equity, the company generated $0.11 in profit.
Does American Water Works Company Have A Good Return On Equity?
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 American Water Works Company has an ROE that is roughly in line with the Water Utilities industry average (9.8%).
So while the ROE is not exceptional, at least its acceptable. Even if the ROE is respectable when compared to the industry, its worth checking if the firm's ROE is being aided by high debt levels. If a company takes on too much debt, it is at higher risk of defaulting on interest payments.
How Does Debt Impact ROE?
Most companies need money -- from somewhere -- 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. Thus the use of debt can improve ROE, albeit along with extra risk in the case of stormy weather, metaphorically speaking.
American Water Works Company's Debt And Its 11% ROE
It's worth noting the high use of debt by American Water Works Company, leading to its debt to equity ratio of 1.64. The combination of a rather low ROE and significant use of debt is not particularly appealing. Debt increases risk and reduces options for the company in the future, so you generally want to see some good returns from using it.