While some investors are already familiar with financial metrics (hat tip), this article is for those who want to learn more about return on equity (ROE) and why it’s important. As a learning-by-doing, we’ll take a look at the ROE to better understand Norfolk Southern Corporation (NYSE: NSC).
Return on equity or ROE is an important factor for a shareholder to consider because it tells them how efficiently their capital is being reinvested. In other words, it is a profitability ratio that measures the rate of return on capital contributed by the shareholders of the company.
Check out our latest review for Norfolk Southern
How do you calculate return on equity?
ROE can be calculated using the formula:
Return on equity = Net income (from continuing operations) Ã· Equity
So, based on the above formula, Norfolk Southern’s ROE is:
21% = US $ 2.9 billion Ã· US $ 14 billion (based on the last twelve months to September 2021).
âReturnâ refers to a company’s profits over the past year. Another way to look at this is that for every dollar of equity, the company was able to make $ 0.21 in profit.
Does Norfolk Southern have a good return on equity?
A simple way to determine if a company has a good return on equity is to compare it to the average in its industry. However, this method is only useful as a rough check, as companies differ a bit within the same industry classification. You can see in the graph below that Norfolk Southern has a ROE quite close to the transport industry average (18%).
It’s no wonder, but it’s respectable. Although the ROE is similar to that of the industry, we still need to perform additional checks to see if the company’s ROE is being boosted by high levels of debt. If so, it increases their exposure to financial risk.
What is the impact of debt on return on equity?
Almost all businesses need money to invest in the business, to increase their profits. The money for the investment can come from the profits of the previous year (retained earnings), from the issuance of new shares or from loans. In the first and second cases, the ROE will reflect this use of cash for investing in the business. In the latter case, the use of debt will improve returns, but will not affect equity. So, using debt can improve ROE, but with added risk in stormy weather, metaphorically speaking.
Combine Norfolk Southern debt with its 21% return on equity
Norfolk Southern uses a large amount of debt to increase returns. Its debt to equity ratio is 1.03. There is no doubt that his ROE is decent, but the company’s very high debt is not too exciting to see. Investors should think carefully about how a business will perform if it weren’t able to borrow so easily, as credit markets change over time.
Return on equity is a way to compare the business quality of different companies. A business that can earn a high return on equity without going into debt could be considered a high quality business. All other things being equal, a higher ROE is preferable.
But when a company is of high quality, the market often offers it up to a price that reflects that. The rate at which earnings are likely to grow, relative to earnings growth expectations reflected in the current price, must also be considered. So I think it’s worth checking this out free analyst forecast report for the company.
If you would rather consult with another company – one with potentially superior finances – then don’t miss this free list of interesting companies, which have a HIGH return on equity and low leverage.
This Simply Wall St article is general in nature. We provide commentary based on historical data and analyst forecasts using only unbiased methodology and our articles are not intended to be financial advice. It does not constitute a recommendation to buy or sell shares and does not take into account your goals or your financial situation. Our aim is to bring you long-term, targeted analysis based on fundamental data. Note that our analysis may not take into account the latest announcements from price sensitive companies or qualitative documents. Simply Wall St has no position in any of the stocks mentioned.
Do you have any feedback on this item? Are you worried about the content? Get in touch with us directly. You can also send an email to the editorial team (at) simplywallst.com.