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What Telecom Plus PLC’s (LON:TEP) ROE Can Tell Us

One of the best investments we can make is in our own knowledge and skill set. With that in mind, this article will work through how we can use Return On Equity (ROE) to better understand a business. We’ll use ROE to examine Telecom Plus PLC (LON:TEP), by way of a worked example.

Over the last twelve months Telecom Plus has recorded a ROE of 13%. That means that for every £1 worth of shareholders’ equity, it generated £0.13 in profit.

Check out our latest analysis for Telecom Plus

How Do I Calculate Return On Equity?

The formula for return on equity is:

Return on Equity = Net Profit ÷ Shareholders’ Equity

Or for Telecom Plus:

13% = UK£30m ÷ UK£227m (Based on the trailing twelve months to March 2018.)

It’s easy to understand the ‘net profit’ part of that equation, but ‘shareholders’ equity’ requires further explanation. It is all the money paid into the company from shareholders, plus any earnings retained. The easiest way to calculate shareholders’ equity is to subtract the company’s total liabilities from the total assets.

What Does Return On Equity Mean?

ROE measures a company’s profitability against the profit it retains, and any outside investments. The ‘return’ is the yearly profit. The higher the ROE, the more profit the company is making. So, all else being equal, a high ROE is better than a low one. That means it can be interesting to compare the ROE of different companies.

Does Telecom Plus 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. The limitation of this approach is that some companies are quite different from others, even within the same industry classification. The image below shows that Telecom Plus has an ROE that is roughly in line with the integrated utilities industry average (11%).

LSE:TEP Last Perf November 16th 18
LSE:TEP Last Perf November 16th 18

That isn’t amazing, but it is respectable. Of course, this year’s ROE might be a product of last year’s decisions. So savvy investors often note how long the CEO has been in that position.

How Does Debt Impact Return On Equity?

Companies usually need to invest money 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 use of debt will improve the returns, but will not change the equity. Thus the use of debt can improve ROE, albeit along with extra risk in the case of stormy weather, metaphorically speaking.

Combining Telecom Plus’s Debt And Its 13% Return On Equity

Telecom Plus has a debt to equity ratio of 0.17, which is far from excessive. Its very respectable ROE, combined with only modest debt, suggests the business is in good shape. Judicious use of debt to improve returns can certainly be a good thing, although it does elevate risk slightly and reduce future optionality.

The Bottom Line On ROE

Return on equity is useful for comparing the quality of different businesses. A company that can achieve a high return on equity without debt could be considered a high quality business. All else being equal, a higher ROE is better.

But ROE is just one piece of a bigger puzzle, since high quality businesses often trade on high multiples of earnings. 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.

But note: Telecom Plus may not be the best stock to buy. So take a peek at this free list of interesting companies with high ROE and low debt.

To help readers see past the short term volatility of the financial market, we aim to bring you a long-term focused research analysis purely driven by fundamental data. Note that our analysis does not factor in the latest price-sensitive company announcements.

The author is an independent contributor and at the time of publication had no position in the stocks mentioned. For errors that warrant correction please contact the editor at editorial-team@simplywallst.com.

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