Many investors are still learning about the different ratios that can be useful when analyzing a stock. This article is for those who want to learn more about return on equity (ROE). To keep the lesson practical, we’ll use ROE to better understand ATCO Ltd. (TSE:ACO.X).
Return on equity (ROE) is a measure of how effectively a company increases its value and manages its investors’ money. In simpler terms, it measures a company’s profitability relative to shareholders’ equity.
Check out our latest analysis for ATCO
How do you calculate return on equity?
ROE can be calculated using the following formula:
Return on equity = Net profit (from continuing operations) ÷ Equity
Based on the above formula, the ROE for ATCO is:
8.5% = CA$730 million ÷ CA$8.6 billion (based on the trailing twelve months to June 2024).
The “return” is the annual profit. You can also imagine it like this: for every Canadian dollar of equity, the company was able to generate 0.08 Canadian dollars in profit.
Does ATCO have a good return on equity?
By comparing a company’s return on equity to the industry average, we can quickly gauge how well it is doing. Importantly, this is far from a perfect measure, as companies within the same industry vary considerably. The image below shows that ATCO’s return on equity is roughly in line with the industry average for integrated utilities (8.7%).
So the return on equity is not exceptional, but it is acceptable. While the return on equity is no lower than the industry, it is still worth checking what role the company’s debt plays, as a high debt-to-equity ratio can also make the return on equity appear high. If a company takes on too much debt, it has a higher risk of defaulting on its interest payments. To learn more about the two risks we have identified for ATCO, visit our free risk dashboard.
Why you should consider debt when looking at ROE
Most companies need money – from somewhere – to grow their profits. The money for investments can come from previous year’s profits (retained earnings), issuing new shares, or borrowing. In the first and second cases, the return on equity reflects this use of cash to invest in the company. In the second case, the debt used for growth improves the return but has no impact on total equity. Thus, the use of debt can improve the return on equity, albeit, metaphorically speaking, with additional risk in stormy weather.
Combination of ATCO’s debt and its return on equity of 8.5%
It’s worth noting ATCO’s high leverage, which results in a debt-to-equity ratio of 1.30. Given a relatively low return on equity and significant leverage, it’s hard to get excited about this business right now. Debt brings additional risk, so it’s only really worth it if a company can generate decent returns from it.
Diploma
Return on equity is a way to compare the business quality of different companies. In our view, the highest quality companies have high return on equity despite having low debt. If two companies have the same return on equity, I would generally prefer the company with the lower debt.
However, if a company is of high quality, the market will often bid it up at a price that reflects this. It is particularly important to consider earnings growth rates compared to expectations reflected in the share price, so you may want to take a look at this data-rich interactive chart showing forecasts for the company.
But please note: ATCO may not be the best stock to buySo take a look at the free List of interesting companies with high return on equity and low debt.
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This Simply Wall St article is of a general nature. We comment solely on historical data and analyst forecasts, using an unbiased methodology. Our articles do not constitute financial advice. It is not a recommendation to buy or sell any stock and does not take into account your objectives or financial situation. Our goal is to provide you with long-term analysis based on fundamental data. Note that our analysis may not take into account the latest price-sensitive company announcements or qualitative materials. Simply Wall St does not hold any of the stocks mentioned.
