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One of the best investments we can make is in our own knowledge and skill set. With that in mind, this article will work through how we can use Return On Equity (ROE) to better understand a business. We'll use ROE to examine PPL Corporation (NYSE:PPL), by way of a worked example.
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 simpler terms, it measures the profitability of a company in relation to shareholder's equity.
View our latest analysis for PPL
How To Calculate Return On Equity?
The formula for return on equity is:
Return on Equity = Net Profit (from continuing operations) ÷ Shareholders' Equity
So, based on the above formula, the ROE for PPL is:
6.0% = US$840m ÷ US$14b (Based on the trailing twelve months to June 2024).
The 'return' is the amount earned after tax over the last twelve months. Another way to think of that is that for every $1 worth of equity, the company was able to earn $0.06 in profit.
Does PPL Have A Good Return On Equity?
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. As shown in the graphic below, PPL has a lower ROE than the average (9.2%) in the Electric Utilities industry classification.
That certainly isn't ideal. Although, we think that a lower ROE could still mean that a company has the opportunity to better its returns with the use of leverage, provided its existing debt levels are low. A company with high debt levels and low ROE is a combination we like to avoid given the risk involved. To know the 3 risks we have identified for PPL visit our risks dashboard for free.
Why You Should Consider Debt When Looking At ROE
Most companies need money -- from somewhere -- to grow their profits. That cash can come from retained earnings, issuing new shares (equity), 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 use of debt will improve the returns, but will not change the equity. Thus the use of debt can improve ROE, albeit along with extra risk in the case of stormy weather, metaphorically speaking.
PPL's Debt And Its 6.0% ROE
PPL clearly uses a high amount of debt to boost returns, as it has a debt to equity ratio of 1.15. The combination of a rather low ROE and significant use of debt is not particularly appealing. Debt increases risk and reduces options for the company in the future, so you generally want to see some good returns from using it.