While some investors are already familiar with financial metrics (hat trick), this article is for those who want to learn more about return on equity (ROE) and why it matters. Learning by doing, we will look at ROE to better understand Kosmos Energy Ltd. (NYSE:KOS).
Return on equity or ROE is a key metric used to gauge how effectively a company’s management is using the company’s capital. In simple terms, it is used to assess the profitability of a company in relation to its equity.
Check out our latest analysis for Kosmos Energy
How do you calculate return on equity?
Return on equity can be calculated using the formula:
Return on equity = Net income (from continuing operations) ÷ Equity
So, based on the above formula, Kosmos Energy’s ROE is:
2.7% = $14 million ÷ $536 million (based on trailing 12 months to March 2022).
The “yield” is the amount earned after tax over the last twelve months. Another way to think about this is that for every dollar of equity, the company was able to make a profit of $0.03.
Does Kosmos Energy have a good ROE?
By comparing a company’s ROE with the average for its industry, we can get a quick measure of its quality. The limitation of this approach is that some companies are very different from others, even within the same industrial classification. If you look at the image below, you can see that Kosmos Energy has a below average ROE (18%) in the oil and gas industry classification.
That’s not what we like to see. However, a low ROE is not always bad. If the company’s debt levels are moderate to low, there is always a chance that returns can be enhanced through the use of leverage. A highly leveraged company with a low ROE is a whole other story and a risky investment on our books. Our risk dashboard should contain the 4 risks we have identified for Kosmos Energy.
Why You Should Consider Debt When Looking at ROE
Most businesses need money – from somewhere – to increase their profits. This money can come from issuing shares, retained earnings or debt. In the case of the first and second options, the ROE will reflect this use of cash, for growth. In the latter case, debt used for growth will enhance returns, but will not affect total equity. This will make the ROE better than if no debt was used.
Combine Kosmos Energy’s debt and its 2.7% return on equity
We believe Kosmos Energy uses a significant amount of debt to maximize its returns, as it has a significantly higher debt-to-equity ratio of 4.69. The combination of a rather low ROE and high debt to equity ratio is negative, in our book.
Return on equity is a way to compare the business quality of different companies. Companies that can earn high returns on equity without too much debt are generally of good quality. All things being equal, a higher ROE is better.
That said, while ROE is a useful indicator of a company’s quality, you’ll need to consider a whole host of factors to determine the right price to buy a stock. It is important to consider other factors, such as future earnings growth and the amount of investment needed in the future. So I think it’s worth checking it out free analyst forecast report for the company.
But note: Kosmos Energy may not be the best stock to buy. So take a look at this free list of interesting companies with high ROE and low debt.
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This Simply Wall St article is general in nature. We provide commentary based on historical data and analyst forecasts only using unbiased methodology and our articles are not intended to be financial advice. It is not a recommendation to buy or sell stocks and does not take into account your objectives or financial situation. Our goal is to bring you targeted long-term analysis based on fundamental data. Note that our analysis may not take into account the latest announcements from price-sensitive companies or qualitative materials. Simply Wall St has no position in the stocks mentioned.