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 Fortis Inc. (EAST: FTS).
Return on equity or ROE is an important factor for a shareholder to consider as it tells them how much of their capital is being reinvested. In other words, it reveals the company’s success in turning shareholders’ investments into profits.
How is ROE calculated?
ROE can be calculated using the formula:
Return on equity = Net income (from continuing operations) ÷ Equity
So, based on the formula above, the ROE of Fortis is:
6.7% = C$1.4 billion ÷ C$21 billion (based on trailing 12 months to March 2022).
“Yield” refers to a company’s earnings over the past year. Another way to think about this is that for every CA$1 of equity, the company was able to make a profit of CA$0.07.
Does Fortis have a good ROE?
By comparing a company’s ROE with the average for its industry, we can get a quick measure of its quality. However, this method is only useful as a rough check, as companies differ quite a bit within the same industry classification. If you look at the image below you can see that Fortis has a below average ROE (9.1%) Electric utility industry classification.
That’s not what we like to see. 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. You can see the 2 risks we have identified for Fortis by visiting our risk dashboard free on our platform here.
What is the impact of debt on return on equity?
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, debt used for growth will enhance returns, but will not affect total equity. Thus, the use of debt can improve ROE, but with an additional risk in the event of a storm, metaphorically speaking.
Fortis’s debt and its ROE of 6.7%
Fortis is clearly using a high amount of debt to boost returns, as it has a leverage ratio of 1.23. Its ROE is quite low, even with the use of significant debt; this is not a good result, in our view. 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. Companies that can earn high returns on equity without too much debt are generally of good quality. 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 when a company is of high quality, the market often gives it a price that reflects that. Earnings growth rates, relative to expectations reflected in the share price, are particularly important to consider. So you might want to take a look at this data-rich interactive chart of business forecasts.