Many investors are still educating themselves about the various metrics that can be useful when analyzing a stock. This article is for those who want to learn more about return on equity (ROE). We’ll use the ROE to take a look at General Electric Company (NYSE: GE), using a real-world example.
Return on equity or ROE is an important factor for a shareholder to consider, as it tells them how effectively their capital is being reinvested. In simpler terms, it measures a company’s profitability relative to equity.
See our latest review for General Electric
How is the ROE calculated?
the formula for ROE is:
Return on equity = Net income (from continuing operations) ÷ Equity
So, based on the above formula, General Electric’s ROE is:
4.6% = US $ 1.8 billion ÷ US $ 39 billion (based on the last twelve months to September 2021).
The “return” is the annual profit. This means that for every dollar in shareholders’ equity, the company generated $ 0.05 in profit.
Does General Electric have a good ROE?
Perhaps the easiest way to assess a company’s ROE is to compare it to the industry average. It is important to note that this measure is far from perfect, as companies differ considerably within a single industry classification. As shown in the image below, General Electric has a lower than average ROE (16%) for the Industrials sector.
Unfortunately, this is suboptimal. However, a low ROE is not always bad. If the company’s debt levels are moderate to low, there is still a chance that returns can be improved through the use of financial leverage. When a company has a low ROE but high levels of debt, we would be careful because the risk involved is too high. Our risk dashboard should contain the 3 risks that we have identified for General Electric.
Why You Should Consider Debt When Looking At ROE
Most businesses need the money – somewhere – to increase their profits. This liquidity can come from the issuance of 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, the debt necessary for growth will increase returns, but will have no impact on equity. In this way, the use of debt will increase the ROE, even if the basic economy of the business remains the same.
General Electric’s debt and its ROE of 4.6%
General Electric is clearly using a high amount of debt to boost returns, as it has a debt-to-equity ratio of 1.61. The combination of a rather low ROE and a high recourse to debt is not particularly attractive. Debt comes with additional risk, so it’s only really worth it when a business is making decent returns from it.
Return on equity is a useful indicator of a company’s ability to generate profits and return them to shareholders. A business that can earn a high return on equity without going into debt can be considered a high quality business. If two companies have roughly the same level of debt to equity and one has a higher ROE, I would generally prefer the one with a higher ROE.
But when a company is of high quality, the market often offers it up to a price that reflects that. Especially important to consider are the growth rates of earnings, relative to expectations reflected in the stock price. So you might want to check out this FREE visualization of analyst forecasts for the business.
But beware : General Electric 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 using only unbiased methodology and our articles are not intended to be financial advice. It does not constitute a recommendation to buy or sell any stock and does not take into account your goals or your financial situation. Our aim is to bring you long-term, targeted analysis based on fundamental data. Note that our analysis may not take into account the latest announcements from price sensitive companies or qualitative documents. Simply Wall St has no position in any of the stocks mentioned.