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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 Severn Trent PLC (LON:SVT), 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. Simply put, it is used to assess the profitability of a company in relation to its equity capital.
View our latest analysis for Severn Trent
How Do You Calculate Return On Equity?
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 Severn Trent is:
14% = UK£132m ÷ UK£971m (Based on the trailing twelve months to March 2023).
The 'return' refers to a company's earnings over the last year. That means that for every £1 worth of shareholders' equity, the company generated £0.14 in profit.
Does Severn Trent 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. As you can see in the graphic below, Severn Trent has a higher ROE than the average (11%) in the Water Utilities industry.
That's clearly a positive. 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. You can see the 3 risks we have identified for Severn Trent by visiting our risks dashboard for free on our platform here.
The Importance Of Debt To Return On Equity
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 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.
Severn Trent's Debt And Its 14% ROE
It appears that Severn Trent makes extensive use of debt to improve its returns, because it has an alarmingly high debt to equity ratio of 7.42. Its ROE is respectable, but it's not so impressive once you consider all of the debt.