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). To keep the lesson grounded in practicality, we’ll use ROE to better understand South Jersey Industries, Inc. (NYSE:SJI).
Return on Equity or ROE is a test of how effectively a company is growing its value and managing investors’ money. In simpler terms, it measures the profitability of a company in relation to shareholder’s equity.
View our latest analysis for South Jersey Industries
How Do You Calculate Return On Equity?
The formula for ROE is:
Return on Equity = Net Profit (from continuing operations) ÷ Shareholders’ Equity
So, based on the above formula, the ROE for South Jersey Industries is:
9.4% = US$157m ÷ US$1.7b (Based on the trailing twelve months to December 2020).
The ‘return’ is the yearly profit. One way to conceptualize this is that for each $1 of shareholders’ capital it has, the company made $0.09 in profit.
Does South Jersey Industries 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. However, this method is only useful as a rough check, because companies do differ quite a bit within the same industry classification. If you look at the image below, you can see South Jersey Industries has a similar ROE to the average in the Gas Utilities industry classification (9.4%).
That isn’t amazing, but it is respectable. Although the ROE is similar to the industry, we should still perform further checks to see if the company’s ROE is being boosted by high debt levels. If true, then it is more an indication of risk than the potential. Our risks dashboardshould have the 2 risks we have identified for South Jersey Industries.
Why You Should Consider Debt When Looking At ROE
Companies usually need to invest money to grow their profits. The cash for investment can come from prior year profits (retained earnings), issuing new shares, or borrowing. In the first two cases, the ROE will capture this use of capital to grow. 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.
South Jersey Industries’ Debt And Its 9.4% ROE
South Jersey Industries clearly uses a high amount of debt to boost returns, as it has a debt to equity ratio of 2.12. The combination of a rather low ROE and significant use of debt is not particularly appealing. Investors should think carefully about how a company might perform if it was unable to borrow so easily, because credit markets do change over time.
Return on equity is useful for comparing the quality of different businesses. A company that can achieve a high return on equity without debt could be considered a high quality business. If two companies have the same ROE, then I would generally prefer the one with less debt.
But when a business is high quality, the market often bids it up to a price that reflects this. It is important to consider other factors, such as future profit growth — and how much investment is required going forward. So you might want to check this FREE visualization of analyst forecasts for the company.
If you would prefer check out another company — one with potentially superior financials — then do not miss this free list of interesting companies, that have HIGH return on equity and low debt.
This article by Simply Wall St is general in nature. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any stocks mentioned.
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