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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 TUI AG (ETR:TUI1), 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. Put another way, it reveals the company's success at turning shareholder investments into profits.
See our latest analysis for TUI
How Is ROE Calculated?
ROE 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 TUI is:
59% = €734m ÷ €1.3b (Based on the trailing twelve months to June 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 €0.59 in profit.
Does TUI 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. As is clear from the image below, TUI has a better ROE than the average (11%) in the Hospitality industry.
That's what we like to see. However, bear in mind that a high ROE doesn’t necessarily indicate efficient profit generation. Aside from changes in net income, a high ROE can also be the outcome of high debt relative to equity, which indicates risk.
How Does Debt Impact 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 required for growth will boost returns, but will not impact the shareholders' equity. That will make the ROE look better than if no debt was used.
TUI's Debt And Its 59% ROE
TUI does use a high amount of debt to increase returns. It has a debt to equity ratio of 1.55. While no doubt that its ROE is impressive, we would have been even more impressed had the company achieved this with lower debt. Debt does bring extra risk, so it's only really worthwhile when a company generates some decent returns from it.
Summary
Return on equity is one way we can compare its business quality of different companies. A company that can achieve a high return on equity without debt could be considered a high quality business. If two companies have around the same level of debt to equity, and one has a higher ROE, I'd generally prefer the one with higher ROE.