One of the best investments we can make is in our own knowledge and skill set. With that in mind, this article will work through how we can use Return On Equity (ROE) to better understand a business. We’ll use ROE to examine United Rentals, Inc. (NYSE:URI), by way of a worked example.
Return on equity or ROE is an important factor to be considered by a shareholder because it tells them how effectively their capital is being reinvested. In other words, it is a profitability ratio which measures the rate of return on the capital provided by the company’s shareholders.
Return on Equity = Net Profit (from continuing operations) ÷ Shareholders’ Equity
So, based on the above formula, the ROE for United Rentals is:
30% = US$2.6b ÷ US$8.6b (Based on the trailing twelve months to September 2024).
The ‘return’ is the yearly profit. That means that for every $1 worth of shareholders’ equity, the company generated $0.30 in profit.
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. As is clear from the image below, United Rentals has a better ROE than the average (17%) in the Trade Distributors industry.
That’s what we like to see. Bear in mind, a high ROE doesn’t always mean superior financial performance. Especially when a firm uses high levels of debt to finance its debt which may boost its ROE but the high leverage puts the company at risk.
Companies usually need to invest money to grow their profits. That cash can come from issuing shares, retained earnings, or debt. 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.
United Rentals clearly uses a high amount of debt to boost returns, as it has a debt to equity ratio of 1.53. Its ROE is pretty impressive but, it would have probably been lower without the use of debt. 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.