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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 WPP plc (LON:WPP), by way of a worked example.
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. In short, ROE shows the profit each dollar generates with respect to its shareholder investments.
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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 WPP is:
15% = UK£624m ÷ UK£4.1b (Based on the trailing twelve months to June 2023).
The 'return' is the profit over the last twelve months. That means that for every £1 worth of shareholders' equity, the company generated £0.15 in profit.
Does WPP Have A Good Return On Equity?
One simple way to determine if a company has a good return on equity is to compare it to the average for its industry. Importantly, this is far from a perfect measure, because companies differ significantly within the same industry classification. As is clear from the image below, WPP has a better ROE than the average (10%) in the Media industry.
That's clearly a positive. Bear in mind, a high ROE doesn't always mean superior financial performance. A higher proportion of debt in a company's capital structure may also result in a high ROE, where the high debt levels could be a huge risk . To know the 2 risks we have identified for WPP visit our risks dashboard for free.
How Does Debt Impact Return On Equity?
Most companies need money -- from somewhere -- to grow their 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 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.
Combining WPP's Debt And Its 15% Return On Equity
WPP clearly uses a high amount of debt to boost returns, as it has a debt to equity ratio of 1.34. There's no doubt its ROE is decent, but the very high debt the company carries is not too exciting to see. Debt increases risk and reduces options for the company in the future, so you generally want to see some good returns from using it.