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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 Babcock International Group PLC (LON:BAB), by way of a worked example.
Return on equity or ROE is an important factor to be considered by a shareholder because it tells them how effectively their capital is being reinvested. Put another way, it reveals the company's success at turning shareholder investments into profits.
See our latest analysis for Babcock International Group
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 Babcock International Group is:
9.1% = UK£34m ÷ UK£371m (Based on the trailing twelve months to September 2023).
The 'return' is the profit over the last twelve months. One way to conceptualize this is that for each £1 of shareholders' capital it has, the company made £0.09 in profit.
Does Babcock International Group Have A Good ROE?
Arguably the easiest way to assess company's ROE is to compare it with the average in its industry. The limitation of this approach is that some companies are quite different from others, even within the same industry classification. You can see in the graphic below that Babcock International Group has an ROE that is fairly close to the average for the Aerospace & Defense industry (10.0%).
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 so, this increases its exposure to financial risk. To know the 3 risks we have identified for Babcock International Group visit our risks dashboard for free.
Why You Should Consider Debt When Looking At 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 use of debt will improve the returns, but will not change the equity. That will make the ROE look better than if no debt was used.
Combining Babcock International Group's Debt And Its 9.1% Return On Equity
Babcock International Group clearly uses a high amount of debt to boost returns, as it has a debt to equity ratio of 2.01. With a fairly low ROE, and significant use of debt, it's hard to get excited about this business at the moment. Debt does bring extra risk, so it's only really worthwhile when a company generates some decent returns from it.