One of the best investments we can make is in our own knowledge and skills. With that in mind, this article will explain how we can use return on equity (ROE) to better understand a business. To keep the lesson grounded in practicality, we’ll use ROE to better understand New Jersey Resources Corporation (NYSE:NJR).
ROE or return on equity is a useful tool for evaluating how effectively a company can generate returns on the investment it has received from its shareholders. In simpler terms, it measures a company’s profitability relative to equity.
Check opportunities and risks within the US gas utility industry.
How do you calculate return on equity?
The ROE formula is:
Return on equity = Net income (from continuing operations) ÷ Equity
So, based on the above formula, the ROE for New Jersey Resources is:
12% = $219 million ÷ $1.8 billion (based on trailing 12 months to June 2022).
“Yield” is the income the business has earned over the past year. One way to conceptualize this is that for every $1 of share capital it has, the firm has made a profit of $0.12.
Do New Jersey Resources Have a Good Return on Equity?
Perhaps the easiest way to assess a company’s ROE is to compare it to the industry average. However, this method is only useful as a rough check, as companies differ quite a bit within the same industry classification. Fortunately, New Jersey Resources has an above-average ROE (8.8%) for the gas utility industry.
It’s a good sign. However, keep in mind that a high ROE does not necessarily indicate efficient profit generation. A higher proportion of debt in a company’s capital structure can also result in a high ROE, where high debt levels could be a huge risk. You can see the 2 risks we have identified for New Jersey resources by visiting our risk dashboard for free on our platform here.
What is the impact of debt on ROE?
Virtually all businesses need money to invest in the business, to increase their profits. The money for the investment can come from the previous year’s earnings (retained earnings), from issuing new shares or from borrowing. In the case of the first and second options, the ROE will reflect this use of cash, for growth. In the latter case, the debt necessary for growth will boost returns, but will not impact equity. This will make the ROE better than if no debt was used.
Combine New Jersey Resources debt and its 12% return on equity
Of note is the high reliance on debt by New Jersey Resources, resulting in a debt-to-equity ratio of 1.63. Although its ROE is quite respectable, the amount of debt the company is currently carrying is not ideal. Debt increases risk and reduces options for the business in the future, so you generally want to see good returns using it.
Return on equity is a useful indicator of a company’s ability to generate profits and return them to shareholders. Companies that can earn high returns on equity without too much debt are generally of good quality. If two companies have roughly the same level of debt and one has a higher ROE, I generally prefer the one with a higher ROE.
That said, while ROE is a useful indicator of a company’s quality, you’ll need to consider a whole host of factors to determine the right price to buy a stock. The rate at which earnings are likely to grow, relative to earnings growth expectations reflected in the current price, should also be considered. So I think it’s worth checking it out free analyst forecast report for the company.
Sure New Jersey Resources May Not Be the Best Stock to Buy. So you might want to see this free collection of other companies that have high ROE and low debt.
Valuation is complex, but we help make it simple.
Find out if New Jersey Resources is potentially overvalued or undervalued by viewing our full analysis, which includes fair value estimates, risks and warnings, dividends, insider trading and financial health.
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This Simply Wall St article is general in nature. We provide commentary based on historical data and analyst forecasts only using unbiased methodology and our articles are not intended to be financial advice. It is not a recommendation to buy or sell stocks and does not take into account your objectives or financial situation. Our goal is to bring you targeted long-term analysis based on fundamental data. Note that our analysis may not take into account the latest announcements from price-sensitive companies or qualitative materials. Simply Wall St has no position in the stocks mentioned.