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. We'll use ROE to examine American Water Works Company, Inc. (NYSE:AWK), by way of a worked example.
Return on equity or ROE is a key measure used to assess how efficiently a company's management is utilizing the company's capital. Put another way, it reveals the company's success at turning shareholder investments into profits.
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 American Water Works Company is:
10% = US$632m ÷ US$6.2b (Based on the trailing twelve months to March 2020).
The 'return' is the income the business earned over the last year. So, this means that for every $1 of its shareholder's investments, the company generates a profit of $0.10.
Does American Water Works Company Have A Good ROE?
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, American Water Works Company has a better ROE than the average (7.7%) in the Water Utilities industry.
That is a good sign. 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 . Our risks dashboardshould have the 2 risks we have identified for American Water Works Company.
The Importance Of Debt To Return On Equity
Most companies need money -- from somewhere -- to grow their 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 debt used for growth will improve returns, but won't affect the total equity. That will make the ROE look better than if no debt was used.
American Water Works Company's Debt And Its 10% ROE
American Water Works Company does use a high amount of debt to increase returns. It has a debt to equity ratio of 1.65. Its ROE is quite low, even with the use of significant debt; that's not a good result, in our opinion. Investors should think carefully about how a company might perform if it was unable to borrow so easily, because credit markets do change over time.
Return on equity is one way we can compare its business quality of different companies. In our books, the highest quality companies have high return on equity, despite low debt. If two companies have around the same level of debt to equity, and one has a higher ROE, I'd generally prefer the one with higher ROE.
Having said that, while ROE is a useful indicator of business quality, you'll have to look at a whole range of factors to determine the right price to buy a stock. The rate at which profits are likely to grow, relative to the expectations of profit growth reflected in the current price, must be considered, too. So I think it may be worth checking this free report on analyst forecasts for the company.
If you would prefer check out another company -- one with potentially superior financials -- then do not miss this free list of interesting companies, that have HIGH return on equity and low debt.
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This article by Simply Wall St is general in nature. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any stocks mentioned. Thank you for reading.