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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. By way of learning-by-doing, we'll look at ROE to gain a better understanding of PPHE Hotel Group Limited (LON:PPH).
Return on equity or ROE is an important factor to be considered by a shareholder because it tells them how effectively their capital is being reinvested. Simply put, it is used to assess the profitability of a company in relation to its equity capital.
Check out our latest analysis for PPHE Hotel Group
How To Calculate Return On Equity?
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 PPHE Hotel Group is:
2.9% = UK£15m ÷ UK£503m (Based on the trailing twelve months to December 2022).
The 'return' is the yearly profit. One way to conceptualize this is that for each £1 of shareholders' capital it has, the company made £0.03 in profit.
Does PPHE Hotel Group 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, PPHE Hotel Group has a lower ROE than the average (8.5%) in the Hospitality industry.
Unfortunately, that's sub-optimal. That being said, a low ROE is not always a bad thing, especially if the company has low leverage as this still leaves room for improvement if the company were to take on more debt. A company with high debt levels and low ROE is a combination we like to avoid given the risk involved.
The Importance Of Debt To Return On Equity
Virtually all companies need money to invest in the business, to grow profits. The cash for investment can come from prior year profits (retained earnings), issuing new shares, or borrowing. 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.
PPHE Hotel Group's Debt And Its 2.9% ROE
It's worth noting the high use of debt by PPHE Hotel Group, leading to its debt to equity ratio of 2.25. The combination of a rather low ROE and significant use of debt is not particularly appealing. Debt increases risk and reduces options for the company in the future, so you generally want to see some good returns from using it.