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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 Hydro One Limited (TSE:H), by way of a worked example.
Return on Equity or ROE is a test of how effectively a company is growing its value and managing investors’ money. In other words, it is a profitability ratio which measures the rate of return on the capital provided by the company's shareholders.
How To Calculate Return On Equity?
The formula for return on equity is:
Return on Equity = Net Profit (from continuing operations) ÷ Shareholders' Equity
So, based on the above formula, the ROE for Hydro One is:
9.6% = CA$1.2b ÷ CA$12b (Based on the trailing twelve months to December 2024).
The 'return' is the income the business earned over the last year. So, this means that for every CA$1 of its shareholder's investments, the company generates a profit of CA$0.10.
See our latest analysis for Hydro One
Does Hydro One 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. 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 Hydro One has an ROE that is roughly in line with the Electric Utilities industry average (9.1%).
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 true, then it is more an indication of risk than the potential. You can see the 2 risks we have identified for Hydro One by visiting our risks dashboard for free on our platform here.
How Does Debt Impact Return On Equity?
Companies usually need to invest money to grow their profits. The cash for investment can come from prior year profits (retained earnings), issuing new shares, or borrowing. In the first and second cases, the ROE will reflect this use of cash for investment in the business. In the latter case, the debt required for growth will boost returns, but will not impact the shareholders' equity. In this manner the use of debt will boost ROE, even though the core economics of the business stay the same.
Combining Hydro One's Debt And Its 9.6% Return On Equity
Hydro One does use a high amount of debt to increase returns. It has a debt to equity ratio of 1.45. 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.