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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. By way of learning-by-doing, we'll look at ROE to gain a better understanding of EnBW Energie Baden-Württemberg AG (ETR:EBK).
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 EnBW Energie Baden-Württemberg
How Do You 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 EnBW Energie Baden-Württemberg is:
27% = €3.9b ÷ €14b (Based on the trailing twelve months to June 2023).
The 'return' is the yearly profit. So, this means that for every €1 of its shareholder's investments, the company generates a profit of €0.27.
Does EnBW Energie Baden-Württemberg Have A Good ROE?
Arguably the easiest way to assess company's ROE is to compare it with the average in its industry. Importantly, this is far from a perfect measure, because companies differ significantly within the same industry classification. As is clear from the image below, EnBW Energie Baden-Württemberg has a better ROE than the average (13%) in the Electric Utilities industry.
That's what we like to see. Bear in mind, a high ROE doesn't always mean superior financial performance. Aside from changes in net income, a high ROE can also be the outcome of high debt relative to equity, which indicates risk. Our risks dashboardshould have the 2 risks we have identified for EnBW Energie Baden-Württemberg.
How Does Debt Impact Return On Equity?
Virtually all companies need money to invest in the business, to grow profits. The cash for investment can come from prior year profits (retained earnings), issuing new shares, or borrowing. In the first two cases, the ROE will capture this use of capital to grow. 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.
EnBW Energie Baden-Württemberg's Debt And Its 27% ROE
It's worth noting the high use of debt by EnBW Energie Baden-Württemberg, leading to its debt to equity ratio of 1.03. There's no doubt the ROE is impressive, but it's worth keeping in mind that the metric could have been lower if the company were to reduce its debt. Investors should think carefully about how a company might perform if it was unable to borrow so easily, because credit markets do change over time.