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. To keep the lesson grounded in practicality, we’ll use ROE to better understand AltaGas Ltd. (TSE: ALA).
ROE or return on equity is a useful tool for evaluating how effectively a company can generate returns on the investment it has received from its shareholders. 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 AltaGas
How is ROE calculated?
Return on equity can be calculated using the formula:
Return on equity = Net income (from continuing operations) ÷ Equity
So, according to the above formula, AltaGas’ ROE is:
6.9% = C$544 million ÷ C$7.9 billion (based on trailing 12 months to September 2021).
The “yield” is the profit of the last twelve months. This therefore means that for every C$1 of investment by its shareholder, the company generates a profit of C$0.07.
Does AltaGas have a good return on equity?
A simple way to determine if a company has a good return on equity is to compare it to the average for its industry. It is important to note that this measure is far from perfect, as companies differ significantly within the same industry classification. If you look at the image below, you can see that AltaGas has a below average ROE (9.1%) in the gas utility industry classification.
It’s certainly not ideal. 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. When a company has a low ROE but a high level of debt, we would be cautious because the risk involved is too high. To learn about the 2 risks we have identified for AltaGas, visit our risk dashboard for free.
What is the impact of debt on ROE?
Companies generally need to invest money to increase their profits. The money for the investment can come from the previous year’s earnings (retained earnings), from issuing new shares or from borrowing. In the first and second case, the ROE will reflect this use of cash for investment in the business. In the latter case, the debt necessary for growth will boost returns, but will not impact equity. Thus, the use of debt can improve ROE, but with an additional risk in the event of a storm, metaphorically speaking.
AltaGas debt and its ROE of 6.9%
AltaGas is clearly using a high amount of debt to boost returns, as it has a leverage ratio of 1.01. With a fairly low ROE and a significant reliance on debt, it is difficult to get enthusiastic about this activity at the moment. Debt increases risk and reduces options for the business in the future, so you generally want to see good returns using it.
Return on equity is useful for comparing the quality of different companies. A company that can earn a high return on equity without going into debt could be considered a high quality company. If two companies have the same ROE, I would generally prefer the one with less debt.
But ROE is only one piece of a larger puzzle, as high-quality companies often trade on high earnings multiples. It is important to consider other factors, such as future earnings growth and the amount of investment needed in the future. You might want to take a look at this data-rich interactive chart of the company’s forecast.
Sure, you might find a fantastic investment by looking elsewhere. So take a look at this free list of interesting companies.
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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.