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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 MetLife, Inc. (NYSE:MET), by way of a worked example.
Return on Equity or ROE is a test of how effectively a company is growing its value and managing investors’ money. Simply put, it is used to assess the profitability of a company in relation to its equity capital.
See our latest analysis for MetLife
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 MetLife is:
12% = US$3.8b ÷ US$31b (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 $0.12 in profit.
Does MetLife Have A Good ROE?
Arguably the easiest way to assess company's ROE is to compare it with the average in its industry. The limitation of this approach is that some companies are quite different from others, even within the same industry classification. The image below shows that MetLife has an ROE that is roughly in line with the Insurance industry average (14%).
That isn't amazing, but it is respectable. Even if the ROE is respectable when compared to the industry, its worth checking if the firm's ROE is being aided by high debt levels. If so, this increases its exposure to financial risk.
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 case of the first and second options, the ROE will reflect this use of cash, for growth. In the latter case, the use of debt will improve the returns, but will not change the equity. In this manner the use of debt will boost ROE, even though the core economics of the business stay the same.
MetLife's Debt And Its 12% ROE
It's worth noting the high use of debt by MetLife, leading to its debt to equity ratio of 1.51. Its ROE is quite low, even with the use of significant debt; that's not a good result, in our opinion. Debt does bring extra risk, so it's only really worthwhile when a company generates some decent returns from it.
Conclusion
Return on equity is a useful indicator of the ability of a business to generate profits and return them to shareholders. In our books, the highest quality companies have high return on equity, despite low debt. If two companies have the same ROE, then I would generally prefer the one with less debt.