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Did Petrofac Limited (LON:PFC) Use Debt To Deliver Its ROE Of 6.0%?

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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 Petrofac Limited (LON:PFC), by way of a worked example.

Over the last twelve months Petrofac has recorded a ROE of 6.0%. That means that for every £1 worth of shareholders' equity, it generated £0.060 in profit.

See our latest analysis for Petrofac

How Do I Calculate Return On Equity?

The formula for ROE is:

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Return on Equity = Net Profit ÷ Shareholders' Equity

Or for Petrofac:

6.0% = US$64m ÷ US$1.0b (Based on the trailing twelve months to December 2018.)

Most know that net profit is the total earnings after all expenses, but the concept of shareholders' equity is a little more complicated. It is the capital paid in by shareholders, plus any retained earnings. The easiest way to calculate shareholders' equity is to subtract the company's total liabilities from the total assets.

What Does ROE Signify?

ROE measures a company's profitability against the profit it retains, and any outside investments. The 'return' is the yearly profit. The higher the ROE, the more profit the company is making. So, as a general rule, a high ROE is a good thing. That means ROE can be used to compare two businesses.

Does Petrofac Have A Good ROE?

One simple way to determine if a company has a good return on equity is to compare it to the average for its industry. However, this method is only useful as a rough check, because companies do differ quite a bit within the same industry classification. If you look at the image below, you can see Petrofac has a similar ROE to the average in the Energy Services industry classification (7.2%).

LSE:PFC Past Revenue and Net Income, March 31st 2019
LSE:PFC Past Revenue and Net Income, March 31st 2019

That's not overly surprising. ROE can give us a view about company quality, but many investors also look to other factors, such as whether there are insiders buying shares. If you are like me, then you will not want to miss this free list of growing companies that insiders are buying.

How Does Debt Impact ROE?

Companies usually need to invest money to grow their profits. That cash can come from retained earnings, issuing new shares (equity), 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 used for growth will improve returns, but won't affect the total equity. That will make the ROE look better than if no debt was used.

Petrofac's Debt And Its 6.0% ROE

Petrofac clearly uses a significant amount debt to boost returns, as it has a debt to equity ratio of 1.08. While the ROE isn't too bad, it would probably be a lot lower if the company was forced to reduce debt. Investors should think carefully about how a company might perform if it was unable to borrow so easily, because credit markets do change over time.

But It's Just One Metric

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 when a business is high quality, the market often bids it up to a price that reflects this. The rate at which profits are likely to grow, relative to the expectations of profit growth reflected in the current price, must be considered, too. So I think it may be worth checking this free report on analyst forecasts for the company.

Of course Petrofac may not be the best stock to buy. So you may wish to see this free collection of other companies that have high ROE and low debt.

We aim to bring you long-term focused research analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material.

If you spot an error that warrants correction, please contact the editor at editorial-team@simplywallst.com. This article by Simply Wall St is general in nature. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. Simply Wall St has no position in the stocks mentioned. Thank you for reading.