Many investors are still educating themselves on the various metrics that can be useful when analyzing a stock. This article is for those who want to learn more about return on equity (ROE). As a learning-by-doing, we’ll take a look at the ROE to better understand BW Energy Limited (OB: BWE).
Return on equity or ROE is a key metric used to assess the efficiency with which the management of a business is using business capital. In other words, it reveals the company’s success in turning shareholders’ investments into profits.
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How to calculate return on equity?
Return on equity can be calculated using the formula:
Return on equity = Net income (from continuing operations) Ã· Equity
So, based on the above formula, BW Energy’s ROE is:
2.1% = US $ 12 million Ã· US $ 540 million (based on the last twelve months to June 2021).
The âreturnâ is the annual profit. One way to conceptualize this is that for every NOK1 of shareholders’ capital it has, the company made a profit of NOK 0.02.
Does BW Energy have a good return on equity?
Perhaps the easiest way to assess a company’s ROE is to compare it to the industry average. The limitation of this approach is that some companies are very different from others, even within the same industry classification. If you look at the image below, you can see that BW Energy has a lower than average ROE (15%) in the classification of the oil and gas industry.
It is certainly not ideal. However, a low ROE is not always bad. If the company’s debt levels are moderate to low, there is still a chance that returns can be improved through the use of financial leverage. A highly leveraged business with a low ROE is a whole different story and a risky investment on our books.
The importance of debt to return on equity
Businesses generally need to invest money 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 two cases, the ROE will capture this use of capital to grow. In the latter case, the use of debt will improve returns, but will not affect equity. This will make the ROE better than if no debt was used.
BW Energy’s debt and its ROE of 2.1%
A positive point for shareholders is that BW Energy has no net debt! So even though I find his ROE to be rather low, at least he hasn’t used any debt. After all, when a business has a strong balance sheet, it can often find ways to invest in growth, even if it takes a while.
Return on equity is a useful indicator of a company’s ability to generate profits and return them to shareholders. In our books, the highest quality companies have a high return on equity, despite low leverage. If two companies have roughly the same level of debt to equity and one has a higher ROE, I would generally prefer the one with a higher ROE.
That said, while ROE is a useful indicator of how good a business is, you’ll need to look at a whole range of factors to determine the right price to buy a stock. Especially important to consider are the growth rates of earnings, relative to expectations reflected in the stock price. You might want to take a look at this data-rich interactive chart of the forecast for the business.
But beware : BW Energy may not be the best stock to buy. So take a look at this free list of interesting companies with high ROE and low debt.
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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 material. Simply Wall St has no position in the mentioned stocks.
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