In This Article:
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. To keep the lesson grounded in practicality, we’ll use ROE to better understand Mercury NZ Limited (NZSE:MCY).
Our data shows Mercury NZ has a return on equity of 7.1% for the last year. One way to conceptualize this, is that for each NZ$1 of shareholders’ equity it has, the company made NZ$0.071 in profit.
See our latest analysis for Mercury NZ
How Do I Calculate Return On Equity?
The formula for return on equity is:
Return on Equity = Net Profit ÷ Shareholders’ Equity
Or for Mercury NZ:
7.1% = NZ$234m ÷ NZ$3.3b (Based on the trailing twelve months to June 2018.)
Most readers would understand what net profit is, but it’s worth explaining the concept of shareholders’ equity. It is the capital paid in by shareholders, plus any retained earnings. Shareholders’ equity can be calculated by subtracting the total liabilities of the company from the total assets of the company.
What Does ROE Mean?
ROE looks at the amount a company earns relative to the money it has kept within the business. The ‘return’ is the profit over the last twelve months. A higher profit will lead to a a higher ROE. So, all else equal, investors should like a high ROE. That means ROE can be used to compare two businesses.
Does Mercury NZ Have A Good ROE?
By comparing a company’s ROE with its industry average, we can get a quick measure of how good it is. However, this method is only useful as a rough check, because companies do differ quite a bit within the same industry classification. As is clear from the image below, Mercury NZ has a better ROE than the average (4.1%) in the electric utilities industry.
That’s what I like to see. We think a high ROE, alone, is usually enough to justify further research into a company. One data point to check is if insiders have bought shares recently.
Why You Should Consider Debt When Looking At ROE
Virtually all companies need money to invest in the business, to grow profits. That cash can come from issuing shares, retained earnings, or debt. In the case of the first and second options, the ROE will reflect this use of cash, for growth. In the latter case, the debt used for growth will improve returns, but won’t affect the total equity. That will make the ROE look better than if no debt was used.
Combining Mercury NZ’s Debt And Its 7.1% Return On Equity
While Mercury NZ does have some debt, with debt to equity of just 0.42, we wouldn’t say debt is excessive. I’m not impressed with its ROE, but the debt levels are not too high, indicating the business has decent prospects. Conservative use of debt to boost returns is usually a good move for shareholders, though it does leave the company more exposed to interest rate rises.