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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 Telstra Corporation Limited (ASX:TLS), by way of a worked example.

Telstra has a ROE of 21%, based on the last twelve months. That means that for every A$1 worth of shareholders' equity, it generated A$0.21 in profit.

View our latest analysis for Telstra

How Do You Calculate ROE?

The formula for return on equity is:

Return on Equity = Net Profit ÷ Shareholders' Equity

Or for Telstra:

21% = AU$3.1b ÷ AU$15b (Based on the trailing twelve months to December 2018.)

Most know that net profit is the total earnings after all expenses, but the concept of shareholders' equity is a little more complicated. It is the capital paid in by shareholders, plus any retained earnings. Shareholders' equity can be calculated by subtracting the total liabilities of the company from the total assets of the company.

What Does ROE Signify?

ROE looks at the amount a company earns relative to the money it has kept within the business. The 'return' is the profit over the last twelve months. That means that the higher the ROE, the more profitable the company is. So, all else being equal, a high ROE is better than a low one. That means ROE can be used to compare two businesses.

Does Telstra Have A Good Return On Equity?

Arguably the easiest way to assess company's ROE is to compare it with the average in its industry. However, this method is only useful as a rough check, because companies do differ quite a bit within the same industry classification. As you can see in the graphic below, Telstra has a higher ROE than the average (8.8%) in the Telecom industry.

That is a good sign. I usually take a closer look when a company has a better ROE than industry peers. For example you might check if insiders are buying shares.

The Importance Of Debt To Return On Equity

Virtually all companies need money to invest in the business, to grow 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 debt required for growth will boost returns, but will not impact the shareholders' equity. In this manner the use of debt will boost ROE, even though the core economics of the business stay the same.