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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 key measure used to assess how efficiently a company's management is utilizing the company's capital. 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 To 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:
13% = UK£230m ÷ UK£1.8b (Based on the trailing twelve months to September 2024).
The 'return' is the profit over the last twelve months. One way to conceptualize this is that for each £1 of shareholders' capital it has, the company made £0.13 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 (3.7%) in the Water Utilities industry.
That's what we like to see. Bear in mind, a high ROE doesn't always mean superior financial performance. A higher proportion of debt in a company's capital structure may also result in a high ROE, where the high debt levels could be a huge risk . You can see the 2 risks we have identified for Severn Trent by visiting our risks dashboard for free on our platform here.
How Does Debt Impact Return On Equity?
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 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. Thus the use of debt can improve ROE, albeit along with extra risk in the case of stormy weather, metaphorically speaking.
Severn Trent's Debt And Its 13% ROE
We think Severn Trent uses a significant amount of debt to maximize its returns, as it has a significantly higher debt to equity ratio of 4.78. Its ROE is decent, but once I consider all the debt, I'm not really impressed.