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. By way of learning-by-doing, we'll look at ROE to gain a better understanding of Palo Alto Networks, Inc. (NASDAQ:PANW).
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 other words, it is a profitability ratio which measures the rate of return on the capital provided by the company's shareholders.
View our latest analysis for Palo Alto Networks
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 Palo Alto Networks is:
36% = US$440m ÷ US$1.2b (Based on the trailing twelve months to July 2023).
The 'return' is the yearly profit. One way to conceptualize this is that for each $1 of shareholders' capital it has, the company made $0.36 in profit.
Does Palo Alto Networks 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. 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, Palo Alto Networks has a higher ROE than the average (10%) in the Software industry.
That's what we like to see. With that said, a high ROE doesn't always indicate high profitability. 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 2 risks we have identified for Palo Alto Networks by visiting our risks dashboard for free on our platform here.
Why You Should Consider Debt When Looking At ROE
Companies usually need to invest money to grow their profits. That cash can come from issuing shares, retained earnings, or debt. 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 used for growth will improve returns, but won't affect the total equity. In this manner the use of debt will boost ROE, even though the core economics of the business stay the same.
Palo Alto Networks' Debt And Its 36% ROE
We think Palo Alto Networks uses a significant amount of debt to maximize its returns, as it has a significantly higher debt to equity ratio of 3.20. While its ROE is no doubt quite impressive, it could give a false impression about the company's returns given that its huge debt could be boosting those returns.