In This Article:
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 Contact Energy Limited (NZSE:CEN), by way of a worked example.
Our data shows Contact Energy has a return on equity of 4.1% for the last year. Another way to think of that is that for every NZ$1 worth of equity in the company, it was able to earn NZ$0.041.
Check out our latest analysis for Contact Energy
How Do I Calculate ROE?
The formula for ROE is:
Return on Equity = Net Profit ÷ Shareholders’ Equity
Or for Contact Energy:
4.1% = NZ$112m ÷ NZ$2.7b (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 all the money paid into the company from shareholders, plus any earnings retained. Shareholders’ equity can be calculated by subtracting the total liabilities of the company from the total assets of the company.
What Does Return On Equity Signify?
ROE measures a company’s profitability against the profit it retains, and any outside investments. The ‘return’ is the amount earned after tax over the last twelve months. That means that the higher the ROE, the more profitable the company is. So, all else equal, investors should like a high ROE. Clearly, then, one can use ROE to compare different companies.
Does Contact Energy 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. Importantly, this is far from a perfect measure, because companies differ significantly within the same industry classification. If you look at the image below, you can see Contact Energy has a similar ROE to the average in the electric utilities industry classification (4.1%).
That’s neither particularly good, nor bad. Of course, this year’s ROE might be a product of last year’s decisions. So I like to check the tenure of the board and CEO, before reaching any conclusions.
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 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. Thus the use of debt can improve ROE, albeit along with extra risk in the case of stormy weather, metaphorically speaking.