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One of the best investments we can make is in our own knowledge and skills. With this in mind, this article explains how we can use Return on Equity (ROE) to better understand a business.
As a hands-on learning, we will review the ER to better understand Telstra Corporation Limited (ASX: TLS).
Telstra has a ROE of 21%, based on the last twelve months.
This means that for every shareholders' equity, it generates a profit of 0.21 AUD.
See our latest badysis for Telstra
How to calculate the ROE?
the formula for ROE is:
Return on Equity = Net Earnings Equity Equity
Or for Telstra:
21% = 3.1 billion Australian dollars 15 15 billion Australian dollars (based on the twelve months preceding December 2018)
It is easy to understand the "net profit" part of this equation, but "equity" requires additional explanation.
These are all the profits retained by the company, plus any capital paid by the shareholders.
The simplest way to calculate equity is to subtract the total liabilities of the company from the total badets.
What does the return on equity mean?
ROE measures the profitability of a company in relation to the profits it retains and to any external investment.
"Return" is the amount earned after tax in the last twelve months.
This means that the higher the ROE, the more profitable the company is.
So, all things being equal, a high ROE is better than a low.
This means that ROE can be used to compare two companies.
Does Telstra have a good RE?
The simplest way to evaluate the ROE of the company is probably to compare it to the average of its sector.
However, this method is only useful as a rough check, as companies differ somewhat in the same industrial clbadification.
As you can see in the graph below, Telstra has above-average ROE (8.8%) in the telecommunications sector.
This is a good sign.
I usually take a closer look at when a company has a better ROE than its peers in the industry.
for example you could check if insiders buy shares.
Why should you consider a debt when you examine the ROE?
Most businesses need money – from somewhere – to increase their profits.
This money can come from issued shares, undistributed profits or debts.
In the case of the first and second options, the ROE will reflect this cash utilization for growth.
In the latter case, the use of debt will improve returns, but will not change equity.
Thus, recourse to debt can improve the ROE, but with additional risk in the event of a storm, in metaphorical terms.
Combination of Telstra's debt and return on equity of 21%
Telstra uses a large amount of debt to increase returns. Its debt ratio is 1.28.
While its ROE is respectable, it should be kept in mind that there is usually a limit to a company's indebtedness.
Indebtedness presents additional risks. It is therefore really useful when a company derives a decent income.
The final result on ROE
Return on equity is useful for comparing the quality of different companies.
A company that can achieve a high return on debt-free equity could be considered a high quality company.
If two companies have the same ROE, I would usually prefer the one with less debt.
But ROE is just one piece of a bigger puzzle, because high-quality companies often trade with high earnings multiples.
It is important to consider other factors, such as future earnings growth – and the amount of investment required.
You may want to take a look at this interactive graph rich in forecast data for the company.
Of course, you could find a fantastic investment by looking elsewhere. So take a look at this free list of interesting companies.
Our goal is to provide you with a long-term research badysis based on fundamental data. Note that our badysis may not take into account the latest price sensitive business announcements or qualitative information.
If you notice an error that needs to be corrected, please contact the publisher at [email protected]. This article from Simply Wall St is of a general nature. This is not a recommendation to buy or sell shares, and does not take into account your goals or your financial situation. Simply Wall St has no position on the actions mentioned. Thanks for the reading.
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