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. To keep the lesson grounded in practicality, we’ll use ROE to better understand Avista Corporation (NYSE: AVA).
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 simple terms, it is used to assess the profitability of a company in relation to its equity.
Check out our latest review for Avista
How do you calculate return on equity?
The return on equity formula is:
Return on equity = Net income (from continuing operations) ÷ Equity
So, based on the above formula, the ROE for Avista is:
6.8% = $151 million ÷ $2.2 billion (based on trailing 12 months to March 2022).
“Yield” refers to a company’s earnings over the past year. One way to conceptualize this is that for every $1 of share capital it has, the firm has made a profit of $0.07.
Does Avista 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, Avista has an ROE below the average (9.2%) of the Integrated Utilities 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 the possibility that returns could 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 have the 4 risks we identified for Avista.
Why You Should Consider Debt When Looking at ROE
Virtually all businesses need money to invest in the business, 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 use of debt will improve returns, but will not change equity. In this way, the use of debt will increase ROE, even though the core economics of the business remains the same.
Combine Avista’s debt and its return on equity of 6.8%
Avista uses a high amount of debt to increase returns. Its debt to equity ratio is 1.17. 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 a useful indicator of a company’s ability to generate profits and return them to shareholders. In our books, the highest quality companies have a high return on equity, despite low leverage. 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. 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 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.