Many investors are still learning about the various metrics that can be useful when analysing a stock. This article is for those who would like to learn about Return On Equity (ROE). We'll use ROE to examine Evoqua Water Technologies Corp. (NYSE:AQUA), by way of a worked example.
Return on Equity or ROE is a test of how effectively a company is growing its value and managing investors’ money. In other words, it is a profitability ratio which measures the rate of return on the capital provided by the company's shareholders.
How Do You Calculate Return On Equity?
The formula for return on equity is:
Return on Equity = Net Profit (from continuing operations) ÷ Shareholders' Equity
So, based on the above formula, the ROE for Evoqua Water Technologies is:
8.9% = US$52m ÷ US$582m (Based on the trailing twelve months to September 2021).
The 'return' is the yearly profit. That means that for every $1 worth of shareholders' equity, the company generated $0.09 in profit.
Does Evoqua Water Technologies Have A Good Return On Equity?
Arguably the easiest way to assess company's ROE is to compare it with the average in its industry. Importantly, this is far from a perfect measure, because companies differ significantly within the same industry classification. You can see in the graphic below that Evoqua Water Technologies has an ROE that is fairly close to the average for the Machinery industry (10%).
That isn't amazing, but it is respectable. While at least the ROE is not lower than the industry, its still worth checking what role the company's debt plays as high debt levels relative to equity may also make the ROE appear high. If a company takes on too much debt, it is at higher risk of defaulting on interest payments. Our risks dashboardshould have the 3 risks we have identified for Evoqua Water Technologies.
The Importance Of Debt To Return On Equity
Companies usually need to invest money to grow their profits. That cash can come from retained earnings, issuing new shares (equity), or debt. In the first and second cases, the ROE will reflect this use of cash for investment in the business. In the latter case, the debt used for growth will improve returns, but won't affect the total equity. In this manner the use of debt will boost ROE, even though the core economics of the business stay the same.
Evoqua Water Technologies' Debt And Its 8.9% ROE
Evoqua Water Technologies does use a high amount of debt to increase returns. It has a debt to equity ratio of 1.28. Its ROE is quite low, even with the use of significant debt; that's not a good result, in our opinion. Debt increases risk and reduces options for the company in the future, so you generally want to see some good returns from using it.
Return on equity is a useful indicator of the ability of a business to generate profits and return them to shareholders. In our books, the highest quality companies have high return on equity, despite low debt. If two companies have the same ROE, then I would generally prefer the one with less debt.
But ROE is just one piece of a bigger puzzle, since high quality businesses often trade on high multiples of earnings. The rate at which profits are likely to grow, relative to the expectations of profit growth reflected in the current price, must be considered, too. So you might want to take a peek at this data-rich interactive graph of forecasts for the company.
Of course, you might find a fantastic investment by looking elsewhere. So take a peek at this free list of interesting companies.
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