Many investors are still educating themselves about the various metrics that can be useful when analyzing a stock. This article is for those who want to learn more about return on equity (ROE). To keep the lesson practical, we will use ROE to better understand BT Group plc (LON: BT.A).

Return on equity or ROE is a key metric used to assess the efficiency with which the management of a business is using business capital. In simpler terms, it measures a company’s profitability relative to equity.

Check out our latest analysis for BT Group

How is the ROE calculated?

The formula for ROE is:

Return on equity = Net income (from continuing operations) ÷ Equity

Thus, on the basis of the above formula, the ROE of BT Group is:

8.8% = 1.0 billion pounds sterling 12 billion pounds sterling (based on the last twelve months to June 2021).

“Return” refers to a company’s profits over the past year. Another way to look at this is that for every £ 1 worth of equity, the company was able to make £ 0.09 in profit.

Does BT Group have a good ROE?

A simple way to determine if a company has a good return on equity is to compare it to the average in its industry. The limitation of this approach is that some companies are very different from others, even within the same industry classification. If you look at the image below, you can see that BT Group has a lower than average ROE (14%) for the telecom industry classification.

LSE: BT.A Return on equity October 29, 2021

Unfortunately, this is suboptimal. However, a low ROE is not always bad. If the company’s debt levels are moderate to low, there is still a chance that returns can be improved through the use of financial leverage. A company with a high level of debt and a low ROE is a combination that we like to avoid given the risk involved. Our risk dashboard must contain the 4 risks that we have identified for BT Group.

The importance of debt to return on equity

Most businesses need money – from somewhere – to increase their profits. The money for the investment can come from the profits of the previous year (retained earnings), from the issuance of new shares or from loans. 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 used for growth will improve returns, but will not affect total equity. This will make the ROE better than if no debt was used.

Combine BT Group’s debt and its 8.8% return on equity

Noteworthy is the high reliance on debt by BT Group, which has given it a debt-to-equity ratio of 1.96. With a fairly low ROE and heavy use of debt, it’s hard to get excited about this business right now. Debt comes with additional risk, so it’s only really worth it when a business is making decent returns from it.

Conclusion

Return on equity is a way to compare the quality of the business of different companies. In our books, the highest quality companies have a high return on equity, despite low leverage. All other things being equal, a higher ROE is preferable.

That said, while ROE is a useful indicator of how good a business is, you’ll need to look at a whole range 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, must also be considered. So I think it’s worth checking this out free analyst forecast report for the company.

Sure BT Group might not be the best stock to buy. So you might want to see this free collection of other companies with high ROE and low leverage.

This Simply Wall St article is general in nature. We provide commentary based on historical data and analyst forecasts using only unbiased methodology and our articles are not intended to be financial advice. It does not constitute a recommendation to buy or sell shares and does not take into account your goals or your financial situation. Our aim is to bring you long-term, targeted analysis based on fundamental data. Note that our analysis may not take into account the latest announcements from price sensitive companies or qualitative material. Simply Wall St has no position in the mentioned stocks.

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