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 ROE to better understand Avaya Holdings Corp. (NYSE: AVYA).
Return on equity or ROE is a test of how effectively a company increases its value and manages investor money. 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 Avaya Holdings
How do you calculate return on equity?
the return on equity formula is:
Return on equity = Net income (from continuing operations) ÷ Equity
Thus, based on the above formula, the ROE of Avaya Holdings is:
3.9% = US $ 18 million ÷ US $ 463 million (based on the last twelve months to June 2021).
The “return” is the income the business has earned over the past year. This means that for every dollar in shareholders’ equity, the company generated $ 0.04 in profit.
Does Avaya Holdings 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. As shown in the graph below, Avaya Holdings has a lower than average ROE (13%) for the software industry classification.
Unfortunately, this is suboptimal. 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. When a company has a low ROE but high levels of debt, we would be careful because the risk involved is too high. You can see the 3 risks we have identified for Avaya Holdings by visiting our risk dashboard for free on our platform here.
The importance of debt to return on equity
Most businesses need money – from somewhere – to increase their profits. This liquidity can come from retained earnings, the issuance of new shares (shares) or debt. In the first and second cases, the ROE will reflect this use of cash for investing in the business. In the latter case, the debt necessary for growth will increase returns, but will have no impact on equity. This will make the ROE better than if no debt was used.
Combine Avaya Holdings Debt and 3.9% Return on Equity
It appears that Avaya Holdings relies heavily on debt to improve its returns, as its debt-to-equity ratio is alarmingly high at 6.06. The combination of a rather low ROE and a high debt ratio is negative, in our book.
Return on equity is useful for comparing the quality of different companies. Firms that can earn high returns on equity without taking on too much debt are generally of good quality. If two companies have the same ROE, then I would generally prefer the one with the least amount of debt.
But ROE is only one piece of a bigger puzzle, as high-quality companies often trade at high earnings multiples. It is important to take into account other factors, such as future profit growth and the amount of investment required for the future. You might want to take a look at this data-rich interactive chart of the forecast for the business.
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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 any of the stocks mentioned.
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