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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. To keep the lesson grounded in practicality, we'll use ROE to better understand Jupiter Energy Limited (ASX:JPR).
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 simpler terms, it measures the profitability of a company in relation to shareholder's equity.
See our latest analysis for Jupiter Energy
How Is ROE Calculated?
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 Jupiter Energy is:
50% = AU$1.9m ÷ AU$3.7m (Based on the trailing twelve months to June 2024).
The 'return' is the yearly profit. One way to conceptualize this is that for each A$1 of shareholders' capital it has, the company made A$0.50 in profit.
Does Jupiter Energy 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. However, this method is only useful as a rough check, because companies do differ quite a bit within the same industry classification. As is clear from the image below, Jupiter Energy has a better ROE than the average (15%) in the Oil and Gas industry.
That's clearly a positive. Bear in mind, a high ROE doesn't always mean superior financial performance. 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 5 risks we have identified for Jupiter Energy by visiting our risks dashboard for free on our platform here.
How Does Debt Impact Return On Equity?
Most companies need money -- from somewhere -- 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. Thus the use of debt can improve ROE, albeit along with extra risk in the case of stormy weather, metaphorically speaking.
Jupiter Energy's Debt And Its 50% ROE
We think Jupiter Energy uses a significant amount of debt to maximize its returns, as it has a significantly higher debt to equity ratio of 5.08. 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.