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 Terna – Rete Elettrica Nazionale Società per Azioni (BIT:TRN), by way of a worked example.
Terna – Rete Elettrica Nazionale Società per Azioni has a ROE of 18%, based on the last twelve months. One way to conceptualize this, is that for each €1 of shareholders’ equity it has, the company made €0.18 in profit.
How Do You Calculate Return On Equity?
The formula for return on equity is:
Return on Equity = Net Profit ÷ Shareholders’ Equity
Or for Terna – Rete Elettrica Nazionale Società per Azioni:
18% = 701 ÷ €4.1b (Based on the trailing twelve months to September 2018.)
Most readers would understand what net profit is, but it’s worth explaining the concept of shareholders’ equity. It is all earnings retained by the company, plus any capital paid in by shareholders. The easiest way to calculate shareholders’ equity is to subtract the company’s total liabilities from the total assets.
What Does Return On Equity Signify?
ROE looks at the amount a company earns relative to the money it has kept within the business. The ‘return’ is the amount earned after tax over the last twelve months. That means that the higher the ROE, the more profitable the company is. So, as a general rule, a high ROE is a good thing. Clearly, then, one can use ROE to compare different companies.
Does Terna – Rete Elettrica Nazionale Società per Azioni 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. Importantly, this is far from a perfect measure, because companies differ significantly within the same industry classification. As you can see in the graphic below, Terna – Rete Elettrica Nazionale Società per Azioni has a higher ROE than the average (7.9%) in the Electric Utilities industry.
That is a good sign. In my book, a high ROE almost always warrants a closer look. For example you might check if insiders are buying shares.
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 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.
Terna – Rete Elettrica Nazionale Società per Azioni’s Debt And Its 18% ROE
Terna – Rete Elettrica Nazionale Società per Azioni clearly uses a significant amount debt to boost returns, as it has a debt to equity ratio of 2.37. while its ROE is respectable, it is worth keeping in mind that there is usually a limit to how much debt a company can use. Debt does bring extra risk, so it’s only really worthwhile when a company generates some decent returns from it.
The Key Takeaway
Return on equity is a useful indicator of the ability of a business to generate profits and return them to shareholders. Companies that can achieve high returns on equity without too much debt are generally of good quality. 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.
But ROE is just one piece of a bigger puzzle, since high quality businesses often trade on high multiples of earnings. Profit growth rates, versus the expectations reflected in the price of the stock, are a particularly important to consider. So you might want to take a peek at this data-rich interactive graph of forecasts for the company.
Of course, you might find a fantastic investment by looking elsewhere. So take a peek at this free list of interesting companies.
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 firstname.lastname@example.org.