Many investors are still learning about the various metrics that can be useful when analysing a stock. This article is for those who would like to learn about Return On Equity (ROE). We'll use ROE to examine Babcock International Group PLC (LON:BAB), by way of a worked example.
Return on equity or ROE is a key measure used to assess how efficiently a company's management is utilizing the company's capital. In short, ROE shows the profit each dollar generates with respect to its shareholder investments.
How Do You Calculate Return On Equity?
Return on equity can be calculated by using the formula:
Return on Equity = Net Profit (from continuing operations) ÷ Shareholders' Equity
So, based on the above formula, the ROE for Babcock International Group is:
24% = UK£168m ÷ UK£702m (Based on the trailing twelve months to March 2022).
The 'return' is the amount earned after tax over the last twelve months. That means that for every £1 worth of shareholders' equity, the company generated £0.24 in profit.
Does Babcock International Group Have A Good Return On Equity?
One simple way to determine if a company has a good return on equity is to compare it to the average for its industry. Importantly, this is far from a perfect measure, because companies differ significantly within the same industry classification. As is clear from the image below, Babcock International Group has a better ROE than the average (12%) in the Aerospace & Defense industry.
That's clearly a positive. Bear in mind, a high ROE doesn't always mean superior financial performance. Especially when a firm uses high levels of debt to finance its debt which may boost its ROE but the high leverage puts the company at risk. You can see the 2 risks we have identified for Babcock International Group by visiting our risks dashboard for free on our platform here.
The Importance Of Debt To Return On Equity
Companies usually need to invest money to grow their profits. The cash for investment can come from prior year profits (retained earnings), issuing new shares, or borrowing. In the first two cases, the ROE will capture this use of capital to grow. In the latter case, the use of debt will improve the returns, but will not change the equity. Thus the use of debt can improve ROE, albeit along with extra risk in the case of stormy weather, metaphorically speaking.
Babcock International Group's Debt And Its 24% ROE
Babcock International Group does use a high amount of debt to increase returns. It has a debt to equity ratio of 2.44. While no doubt that its ROE is impressive, we would have been even more impressed had the company achieved this with lower debt. Debt increases risk and reduces options for the company in the future, so you generally want to see some good returns from using it.
Return on equity is a useful indicator of the ability of a business to generate profits and return them to shareholders. Companies that can achieve high returns on equity without too much debt are generally of good quality. All else being equal, a higher ROE is better.
But ROE is just one piece of a bigger puzzle, since high quality businesses often trade on high multiples of earnings. Profit growth rates, versus the expectations reflected in the price of the stock, are a particularly important to consider. So I think it may be worth checking this free report on analyst forecasts for the company.
But note: Babcock International Group may not be the best stock to buy. So take a peek at this free list of interesting companies with high ROE and low debt.
Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.
This article by Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts only using an 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 account of your objectives, or your financial situation. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any stocks mentioned.
Join A Paid User Research Session
You’ll receive a US$30 Amazon Gift card for 1 hour of your time while helping us build better investing tools for the individual investors like yourself. Sign up here