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While some investors are already well versed in financial metrics (hat tip), this article is for those who want to learn more about return on equity (ROE) and why it matters. To keep the lesson hands-on, we’ll use ROE to better understand United Utilities Group PLC (LON:UU.).
Return on Equity or ROE is an important factor to consider by a shareholder as it tells them how effectively their capital is being reinvested. Put simply, it measures a company’s profitability in relation to its equity.
Check out our latest analysis for United Utilities Group
How do you calculate return on equity?
the Formula for return on equity is:
Return on Equity = Net Income (from continuing operations) ÷ Equity
So, based on the formula above, the ROE for the United Utilities Group is:
2.8% = £75m ÷ £2.7bn (based on trailing 12 months to September 2021).
The “return” is the annual profit. Another way to think of it is that for every £1 of equity the company was able to make £0.03 of profit.
Does United Utilities Group have a good return on equity?
Arguably the easiest way to evaluate a company’s ROE is to compare it to its industry average. However, this method only makes sense as a rough check, since companies within the same industry classification are quite different. If you look at the image below, you can see that United Utilities Group has a lower ROE than the average (5.1%) in the water utility industry classification.
That’s definitely not ideal. That being said, low ROE isn’t always a bad thing, especially when the company has low leverage, as that still leaves room for improvement if the company were to borrow more. A highly leveraged company with a low ROE is a whole different story and a risky investment on our books. Our risk dashboard should contain the 3 risks we have identified for United Utilities Group.
How does debt affect return on equity?
Almost all companies need money to invest in the business and make a profit. This money can come from issuance of stock, retained earnings, or debt. In the first two cases, ROE captures this capital investment for growth. In the latter case, the use of debt will improve returns but will not change equity. This makes the ROE look better than if no debt were used.
United Utilities Group’s debt and its 2.8% ROE
It appears that United Utilities Group is using debt extensively to improve its returns, as it has an alarmingly high debt-to-equity ratio of 3.09. The combination of a rather low ROE and high gearing is negative in our opinion.
Conclusion
Return on equity is a way to compare the business quality of different companies. On our books, the highest quality companies have high returns on equity despite low levels of debt. All other things being equal, higher ROE is better.
But ROE is just one piece of a larger puzzle, as high-quality companies often trade at high profit multiples. The rate at which earnings are expected to grow relative to earnings growth expectations reflected in the current price also needs to be considered. You might want to take a look at this data-rich interactive chart of forecasts for the company.
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This Simply Wall St article is of a general nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended as financial advice. It is not a recommendation to buy or sell any stock and does not take into account your goals or financial situation. Our goal is to offer you long-term focused analysis based on fundamental data. Note that our analysis may not take into account the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any of the stocks mentioned.
