One of the best investments we can make is in our own knowledge and skills. With that in mind, this article will explain how we can use return on equity (ROE) to better understand a business. Learning by doing, we will look at ROE to better understand HomeServe plc (LON:HSV).
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 other words, it is a profitability ratio that measures the rate of return on capital contributed by the company’s shareholders.
Check out our latest analysis for HomeServe
How do you calculate return on equity?
the return on equity formula East:
Return on equity = Net income (from continuing operations) ÷ Equity
So, based on the above formula, the ROE for HomeServe is:
7.2% = £38m ÷ £532m (based on trailing 12 months to September 2021).
“Yield” is the income the business has earned over the past year. This means that for every £1 of equity, the company generated £0.07 of profit.
Does HomeServe 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 significantly within the same industry classification. As shown in the graph below, HomeServe has a below average ROE (12%) in the business services industry classification.
Unfortunately, this is suboptimal. That being said, a low ROE is not always a bad thing, especially if the company has low debt, as it still leaves room for improvement if the company were to take on more debt. A company with high debt levels and low ROE is a combination we like to avoid given the risk involved. To learn about the 5 risks we’ve identified for HomeServe, visit our Risk Dashboard for free.
What is the impact of debt on ROE?
Most businesses need money – from somewhere – to increase their profits. This money can come from retained earnings, issuing new stock (shares), or debt. In the first two cases, the ROE will capture this use of capital to grow. In the latter case, the debt necessary for growth will boost returns, but will not impact equity. This will make the ROE better than if no debt was used.
HomeServe’s debt and its ROE of 7.2%
HomeServe is clearly using a high amount of debt to boost returns, as it has a debt-to-equity ratio of 1.37. Its ROE is quite low, even with the use of significant debt; this is not a good result, in our opinion. Investors need to think carefully about how a company would perform if it weren’t able to borrow so easily, as credit markets change over time.
Return on equity is useful for comparing the quality of different companies. In our books, the highest quality companies have a high return on equity, despite low leverage. If two companies have roughly the same level of debt and one has a higher ROE, I generally prefer the one with a higher ROE.
But ROE is only one piece of a larger puzzle, as high-quality companies often trade on high earnings multiples. The rate at which earnings are likely to grow, relative to earnings growth expectations reflected in the current price, should also be considered. You might want to check out this FREE analyst forecast visualization for the company.
If you’d rather check out another company – one with potentially superior finances – then don’t miss this free list of interesting companies, which have a HIGH return on equity and a low indebtedness.
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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.