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 Pendragon PLC (LON:PDG).
Return on equity or ROE is a key measure used to assess how efficiently a company's management is utilizing the company's capital. In other words, it is a profitability ratio which measures the rate of return on the capital provided by the company's shareholders.
Check out our latest analysis for Pendragon
How Is ROE Calculated?
Return on equity 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 Pendragon is:
29% = UK£66m ÷ UK£226m (Based on the trailing twelve months to December 2021).
The 'return' refers to a company's earnings over the last year. So, this means that for every £1 of its shareholder's investments, the company generates a profit of £0.29.
Does Pendragon 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 you can see in the graphic below, Pendragon has a higher ROE than the average (18%) in the Specialty Retail industry.
That is a good sign. With that said, a high ROE doesn't always indicate high profitability. Especially when a firm uses high levels of debt to finance its debt which may boost its ROE but the high leverage puts the company at risk. Our risks dashboardshould have the 3 risks we have identified for Pendragon.
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 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.
Pendragon's Debt And Its 29% ROE
Pendragon clearly uses a high amount of debt to boost returns, as it has a debt to equity ratio of 2.25. 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.